CFM11220a - Understanding derivative contracts: managing risk
Credit default swap: example
Trushan plc group is a large UK construction group which is part
of a consortium engaged in a major building project in a developing
country. The group’s finance company, Trushan Finance plc,
has made a 5-year loan of $300 million, at a market rate of
interest, to the consortium company. Four years remain until the
loan matures. Because of political instability in the region, the
group begins to be concerned that stage payments on the project
might fall into arrear, with the result that the consortium company
might default on interest payments on the loan.
Trushan Finance plc hedges the credit risk by entering into a
4-year credit default swap with a commercial bank.
Under the terms of the swap, each time Trushan Finance plc
receives an interest payment from the consortium company, it pays a
proportion of that interest to the bank. If, for example, the bank
demands 0.5%, the company will pay a ‘premium’ equal to
interest at 0.5% on the $300 million loan – or $375,000 per
quarter ($300 million x 0.5% x 3/12).
In return, the bank undertakes to buy the consortium company
debt at face value from Trushan Finance plc (including any unpaid
interest) if a specified default event occurs. The default event,
or events, will be specified in the derivative contract. It may be
an actual default by the consortium company, or a rescheduling of
payments, or a reduction in the debtor company’s credit
rating below a certain level.
The bank has therefore taken on Trushan group’s credit
exposure, in return for a quite substantial stream of payments. In
effect, the group has insured itself against any default on the
loan to the consortium.
