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Credit default swap and exchange-traded derivatives and over-the-counter derivatives

1. Credit Default Swap (CDS)

1.1. Nature of CDS:

According to Brigham and Houston (1999) a Swap is an agreement in which "two parties agree to exchange obligations to make specified payment streams". Credit Default Swap (CDS) is a form of credit derivative used to hedge the credit risk. It is contract between two parties where one party (the buyer usually Banks) get periodic payment (known as premium) from the other party (the seller usually Insurance company), in which the buyer will pay the debts of seller if the seller default.

1.2. Types of CDS:

1. Single name: A type of CDS provide protection to a single entity

2. CDS Indices: Multiple entities have equal share of the notional amount within the index

3. Basket CDS: CDS with more than one reference entity. Specific types include first-to-default CDS, full basket CDS, un-tranche basket and tranche basket known as a synthetic CDO. (European Central Bank 2009)

1.3. Purpose of CDS:

CDS allows managers to concentrate on running their core business without having to worry about interest rate, currency and commodity price variability. There are usually two motives of CDS i.e., to hedge the associated credit risk with certain form of financing and as a trading tool used for speculative motives (profit earning through successful management of CDS).

2. Difference between Exchange-traded derivatives and Over-The-Counter (OTC) derivatives:

According to Samuels and Wilkes (1990), an exchange-traded derivates is one in "which standardized and completion of the contract guaranteed by the exchange", while OTC is a "where a financial intermediary puts together a transaction which is tailored precisely to the needs of the clients". The distinctions between the exchange-traded derivates and OTC derivatives have been presented in the following table:

3. Advantages and Disadvantages of OTC CDS:

3.1. Advantages of OTC:

1. In order to generate trading volume, OTC derivates options need not to be standardized. This attracts wide range of potential users.

2. OTC derivates are primarily use for hedging the risk. Hence problems that arise due to speculation and its associated burst do not occurred in this market.

3. As no intermediary is involved it saved brokerage and other charges that are paid in case of exchange-traded derivates.

3.1. Disadvantages of OTC:

1. OTC does not enhance the liquidity of the option and thus a higher transactions cost of trading an option.

2. OTC derivatives did not allow new parties to trade an option because there is no exchange involved and hence no one absorbs the counter-party risk of trading the options which increase transactions costs.

3. In case of OTC the market is not regulated and this may lead to macro economic instability.

4. It is very hard to find out the total outstanding notion of the market as this type of market is composed of private parties

5. In case of OTC derivatives the price of the original asset is not transparent price and usually the options are not hedgeable.

References:

European Central Bank (2009), Credit Default Swaps and Counterparty Risk, August 2009, Retrieved February 6, 2010, http://www.ecb.int/pub/pdf/other/creditdefaultswapsandcounterpartyrisk2009en.pdf

Vanhorn James C and Wachowicz John M. (2002) Fundamentals of Financial Management 12th Editiion. USA. Pearson.

Samuels J M., and Wilkes F M. (1990), Management of Company Finance. UK. Thomas Learning

Brigham Eugene F. and Houston Joel F. (1999). Fundamentals of Financial Mnagement 9th Edition. USA. South Western.

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