What is a Credit Event
A credit event is a BAD change in the credit of a borrower that triggers a contingent payment in a credit default swap (CDS). It happens when one defaults on its debt and is not able to comply with the terms of the contract. This results in a credit default swap.
Credit Events and Credit Default Swaps
A credit default swap is when one party, which is the “protection buyer”, pays the other party. Which is the “protection seller” a series of payments over the term of the agreement. What this means, is that the buyer is taking out a form of insurance. On the terms that a debtor will have a credit event. That would thwart its ability to meet its payment as at when due.
Even though credit default swaps appear to be similar to insurance, they are not a type of insurance. Instead, they are more like options because they bet on whether a credit event will or will not occur. Moreover, credit default swaps do not have the analysis of an insurance product, instead, they rely on the financial strength of the entity issuing the asset (loan or bond).
Buying a credit default swap can be a hedge if the buyer is exposed to the debt that involved the borrower. But because CDS contacts are traded, a third party could be betting that:
- The chances of a credit event would increase, and on the other hand, the value of the CDS would rise, or
- A credit event will actually occur, and this would lead to a profitable cash settlement.
Now if no credit event happens during the contract’s term, the seller who receives the premium payments from the buyer would not need to settle the contract, and rather would benefit from receiving the premiums.
Types of Credit Events
According to the International Swaps and Derivatives Association (ISDA), the six credit events include:
- Payment default
- Debt restructuring
- Obligation acceleration
- Obligation default
The three most common credit events include bankruptcies, payment defaults, and debt restructuring. Here they are in detail:
Credit Default Swap
A credit default swap (CDS) is a credit derivative contract between two parties. In a credit default swap, the buyer makes periodic payments to a seller for protection against credit events like the ones mentioned above. A credit default swap is a type of insurance that is geared at the safety of the buyer by transferring the risk of a credit event to someone else.
Is a legal process that happens when one is unable to repay their debts. Bankruptcy is filed by the debtor. A company that is declared bankrupt is also insolvent.
A payment default happens when an individual or organization is unable to make payments on its debts on a timely basis. Continual payment defaults are a precursor to bankruptcy.
Now, people, most times confuse payment default and bankruptcy with one another. But while bankruptcy is telling your creditors that you will not be able to pay them in full, a payment default is telling your creditors that you will not be able to make a payment when it is due.
Debt restructuring is a change in the terms of the debt. Which causes the debt to be less favorable to debt holders. Common examples of debt restructuring include a decrease in the principal amount to be paid, a decline in the coupon rate, a postponement of payment obligations, a longer maturity time, or a change in the ranking of priority of payment.