Credit Ratings LITERATURE REVIEW

17 One of the most important terms in a CDS agreement is the definition of a credit event. According to Fontana and Scheicher, 2010, the credit event described by International Swaps and Derivatives Association are ISDA: 1. Failure to pay principal or coupon when they are due: the failure to pay a coupon might represent a credit event, although most likely one with a high recovery. 2. Restructuring is a change in the terms of a debt obligation that is adverse to creditors, such as a lengthening of the maturity of debt. 3. Repudiation moratorium is occurs when the reference entity rejects or challenges the validity of its obligations. There are some additional credit event added by Bomfim 2005:290 based on ISDA: 4. Bankruptcy is a situation where the reference entity unable to repay its debts. This credit event does not apply to CDS written on sovereign reference entities. 5. Obligation Acceleration occurs when an obligation has become due and payable earlier than it would have otherwise been. When the investors or the buyer of protection decide to protect their bond investment through CDS, they have to pay a periodic payment to the seller of CDS. The periodic payment called premium or spreads. CDS premium tend to be paid quarterly, and the most common maturity are three, five, and ten years, with the five-year maturity being especially active. 18 According to Flannery, et. al, 2010 CDS prices, represent the size of the premium paid by the buyer of protection and are generally known as CDS spreads. CDS spreads change over time based on supply and demand for particular CDS contracts. CDS spreads reflect market participants assessment of the risk of a default or credit event associated with the underlying obligation. The CDS premium or spreads are measured in basis points bps. 1 basis points equals to 0.01. An illustration of CDS premium payment can be seen figure 2.1 Figure 2.1 Credit Default Swap mechanisms Source: Bomfim, 2005 Generally the term of CDS have a similarity with the traditional insurance product. The protection buyers have to pay the premium or spreads Protection Buyer Protection Seller Pay the premium quarterly If reference entity default, seller pays par for the defaulted debt Refrence entity 19 to the protection seller for secure their bond investment from the potential of default by the reference entity. If the reference entity facing the default during the life of the contract, the protection seller will pays the par to the protection buyers. Meanwhile, if the reference entity is not facing the default during the life of the contact, so that, the protection buyers will lose their premium or spread. Unlike the traditional insurance, should not to have any reference assets to buy the CDS. It generally called naked basis. In the CDS spreads payment are known the terms of settlement payment. According to Carboni 2011, the settlement payment is made by the seller according to the contract settlement option. In credit derivatives, there are two options contract of the settlement, they are cash settlement and physical settlement. In the physical settlement, when a credit event occurs, the buyer delivers the reference asset to the seller, in return for which the seller pays the face value par value of the delivered asset to the buyer. The contract may specify a number of alternative assets called deliverable obligations that the buyer can deliver when the default is occur. On the other hand, in the cash settlement option the contract specifies a predetermined payout value when a credit event occurs. Generally, the protection seller pays the buyer the difference between the nominal amount of the default swap and the final market value of the reference asset, determined by the dealer banks. This last value can be viewed as the recovery value of the asset.