Credit derivatives lie at the heart of the structured
credit market and nearly all credit derivatives are based on
credit-default swaps.
These instruments are often poorly understood by outsiders. But a
plain-vanilla single-name credit-default swap is a very
straightforward contract. The complications arise when the swaps
are embedded in larger financial structures or are linked to more
than one name.
A credit-default swap works like an insurance policy. A protection
buyer, most often a bank that owns a loan or bond it wants to
hedge, pays an annual premium to a protection seller. In return,
the protection seller commits itself to making a one-off payment if
the reference credit defaults on any of its debt. The premium is
calculated as a percentage of the underlying asset.
Last month, for example, it cost around 75 basis points to buy
protection on Ford in a five-year contract - the most...
