First American Bank

1. What is a credit default swap?

The Credit Default Swap is designed to transfer credit exposure of fixed income products between parties. The purchaser of Credit Default Swap, also called “protection buyer”, pays periodic fee to the seller, which called “protection seller”, until the contract expired or a credit event occurred. In return, the seller agrees to pay off the third party debt if this party defaults on the loan. The protection seller either received the underlying asset of determined market value of the asset in cash.

2. Why should there be a market for CDS? Who should be the buyers and who should be the sellers of CDS?

There are several reasons why there is a market for CDS. Firstly, it spreads the credit risk to a broad range of investors in a simple and confidential way. Secondly, it can be combined with other risk transfer mechanism, such as loan syndication, to separate the loan into different portions, which can add flexibility to the situation. Finally, it is unfunded and no collateral is needed that it will be appealing to investors.

The buyer of the CDS is the one who pays a spread to buy the protection and goes to short the credit . The seller is one who sell the protection and pays buyer certain amount with predefined credit events occurring.

3. What is the informational value added by creating CDS beyond that given by credit ratings?

The CDS can be combined with another risk transfer mechanism to pass the credit risk from its source to the appropriate investors and separate the loan into different portions.

CDS can also be treated like a speculation instrument. For example, buyer assumes that the third party will default in the future and then can profit from the certain amount it will receive from the seller

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