A credit default swap is a contract that provides protection against credit loss on an underlying reference entity as a result of a specific credit event. A credit event is usually a default or, possibly, a credit downgrade of the entity. The reference entity may be a name, a bond, a loan, a trade receivable or some other type of liability. The buyer of a default swap pays a premium to the writer or seller in exchange for right to receive a payment should a credit event occur. In essence, the buyer is purchasing insurance.
There are two types of conditional payments. One type of payment is a predetermined fixed cash amount. The other type of payment, determined at the time of the credit event, is equal to the difference between the face value and the recovered amount of the reference entity, this payment is made either at the time of the credit event or at the maturity of the contract. There are also several variations of premium payments. The premium may be paid at inception or may be paid over time as a fixed or variable amount. A default swap with a payoff of a fixed amount is known as a binary (cash or nothing) default swap. A default swap with its premium paid at inception is also called a default put.
The value of a default swap depends not only on the credit quality of the underlying reference entity but also on the credit quality of the writer, also referred to as the counterparty. If the counterparty defaults, the buyer of a default swap will not receive any payment if a credit event occurs. We also note that the premium payments end if the counterparty defaults. Hence, the value of a default swap depends on the probability of counterparty default, probability of entity default and the correlation between them.
The recovery rate of a reference entity also plays an important role in default swap valuation. It must be handled carefully. In the case of a bond, its recovery rate can refer to a recovery rate of its principal only or to a recovery rate of both its principal and accrued interests. A recovery rate can also be deterministic or random. However, under the assumption that a recovery rate is independent of other variables, a random recovery rate can be replaced by its expected value and hence only deterministic recovery rates need to be considered.