A contingent credit default swap (CCDS) is a variation of a credit default swap (CDS) where an additional triggering event is required. In a simple CDS, payment under the swap is triggered by a credit event, such as non-payment of interest. In this sense, the CDS acts as an insurance policy on the debt investment. In a contingent credit default swap, the trigger requires both a credit event and another specified event. The specified event is usually a significant movement in an index covering equities, commodities, interest rates, or some other overall measure of the economy or relevant industry. The seller of a CCDS is usually looking for a reference entity that has a low correlation with the credit derivative being protected.
Breaking Down Contingent Credit Default Swap (CCDS)
A contingent credit default swap is closely related to a CDS in that it provides investors a way to reduce their credit risk and counterparty risk in a credit derivative. Credit default swaps kick in when the reference entity misses a payment, files for bankruptcy, disputes the validity of the contract (repudiation) or otherwise impedes the regular payment of their bond/debt. However, there is a whole other side to credit default swaps where they are used to speculate rather than simply hedge. This secondary trading provides secondary demand for normal credit default swaps, making the cost of what was originally meant to be insurance on long-dated debt instruments more expensive than it may be otherwise.
Contingent CDS Versus Regular CDS
A contingent credit default swap is a weaker form of protection than a normal credit default swap. A regular CDS only requires the one trigger — the non-payment or other credit event — while the CCDS requires two triggers before payment. So, the amount of protection being offered is tied back to a benchmark. The contingent CDS is also less attractive as a trading tool because of its complexity and the lower payout amounts and odds when compared to a traditional CDS. A CCDS has become a cheaper form of insurance against counterparty risk than a plain vanilla CDS.
Although the contingent CDS provides a better insurance policy, in that it is targeted to protect against default in a specific case and is priced accordingly, it is a derivative on a derivative. To receive compensation on a CCDS, the reference credit derivative has to be in-the-money for the exposed part, and the other party in the contract has to suffer a credit event. Moreover, the protection being offered is mark-to-market and is adjusted on a daily basis. In short, contingent credit default swaps are complex products tailored to a specific need that an investor — usually an institutional investor — has, so the contract itself requires analysis to understand completely.