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A sovereign default event occurs when a scheduled debt service is not paid in the specified in the debt contract. Unlike the corporation, on the rare
occasion when the government defaults on its debt, it cannot declare for its bankruptcy. Under this situations, creditors and the defaulting borrower
generally exchange or restructuring its debt Ismailescu and Kazemi, 2009.
D. Credit Default Swap
Near the end of 20
th
century, a new derivatives instrument called Credit Default Swap CDS was emerge and introduced as a tools to measure the
sovereign risk Ariefianto and Soepomo, 2011.
A credit default swap is a bilateral agreement between two parties, a buyer and a seller of credit protection. In its simplest form, the protection
buyer agrees to make periodic payments over a predetermined number of years the maturity of the CDS to the protection seller. In exchange, the
protection seller commits to making a payment to the buyer in the event of default by a third party the reference entity. CDS quotes now commonly
relied upon as indicators of investor’s perceptions of credit risk regarding individual firms and their willingness to bear the risk. Bomfim, 2005:68.
Sovereign Credit Default Swap SCDS can be used to protect investors against losses on sovereign debt arising from so-called credit events such as
default or debt restructuring IMF 2013.
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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.
