What Is a Contingent Credit Default Swap (CCDS)?
A contingent credit default swap (CCDS) is a variation of a regular 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 a default on the underlying loan. 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.
- A contingent credit default swap (CCDS) is a modified form of a CDS that requires two triggers, typically a credit event as well as a reading above or below a certain level on an index/benchmark.
- Contingent Credit Default Swaps are typically cheaper than a regular CDS since the odds of payout are lower.
- A CCDS is a more tailored CDS, which makes it more complex and typically needs to be analyzed on a case-by-case basis to determine which form of CDS fits the situation better.
Understanding Credit Default Swaps (CCDSs)
A contingent credit default swap is closely related to a CDS in that it provides investors, mainly financial institutions in this case, a way to reduce their credit risk and counterparty risk when credit and the risk of default are involved.
Credit default swaps kick in when the reference entity (underlying) 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 Credit Default Swap vs. Regular CDS
A contingent credit default swap is a weaker form of protection than a normal credit default swap. A regular CDS only requires one trigger—the non-payment or another credit event—while the CCDS requires two triggers before payment. So, the amount of protection being offered is tied back to a benchmark. The CCDS 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. The flip side of this is that a CCDS is a cheaper form of insurance against counterparty risk than a plain vanilla CDS.
The CCDS is targeted to protect against default in a specific case and is priced accordingly. A CCDS is a derivative on a derivative. To receive compensation on a CCDS, the reference credit derivative has to be in-the-money (ITM) 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 on a case-by-case basis.
Example of How a Contingent Credit Default Swap Works
The value of a CCDS is dependent on two factors: the performance of the underlying loan and exposure to an index or derivative of it.
In a normal CDS, if the obligator fails to pay the underlying loan, the seller of the CDS pays the buyer of the CDS the present value of the loan or a contracted amount.
In a CCDS, the value of the payout will fluctuate based on the performance of the underlying loan as well as the reading of a benchmark or derivative of it. Recall that a CCDS is a derivative of a derivative.
A decrease in the credit quality of the underlying loan will theoretically increase the value of the CCDS, but so will a favorable movement in the index or benchmark. In order for the CCDS buyer to receive a payout, the underlying loan needs to trigger a credit event, such as a missed payment for example, but the index also needs to be at a certain level (or beyond).
That said, the CCDS has a value depending on the likelihood of the payout occurring or not. The price of the CCDS will fluctuate and can be traded on the secondary market, with its value based on the two factors until the underlying loan is paid in full by the obligator or the CCDS triggers a payout.