How does a credit default swap buyer profit when the asset quality deteriorates? How and to whom can he sell it? Can someone help with a real/practical example?
Thanks a bunch in advance.
Ok, so the CDS terms will say that in a credit event, the buyer receives Debt Notional*Recovery Rate. For instance, if Ohai Corporation only pays 60% of some $1,000,000 debt, the CDS buyer gets 40%*$1,000,000.
The value of the CDS contract before such a possible default is approximately (Probability of Default*Debt Notional*Recovery Rate). So, assuming Notional and RR are constance, a higher Probability of Default implies a higher CDS price.
The key thing to consider is that you can go long CDS without being long debt of the same company. This translates into a short credit position.
CDS buyer has bought protection on a referenced asset. The asset quality deteriorates, likeliness of a credit event become eminent, which will kick off the net value reduced to the buyer. So the seller would pay the proceeds to the buyer.
I buy a CDS on a Greece Bond for 10%. The Bonds are trading for 13% lets say. In the face of an immediate credit event, I recieve the cash flows 1m-90K = 910K
You remember synthetic CDO in ABS. It is not real example. But it can help you.
The Portfolio manager buys credit default swap (basically he is short the asset) pays some premium to Junior note holders. When the asset quality goes down, the portfolio manager has the right to sell the asset to the Junior note holders. The portflio manager is paid the par price (?) by delivering the asset or the difference of market price to par.
Pls correct me if I am wrong.