What is a Credit Event
A credit event is any sudden and tangible (negative) change in a borrower's capacity to meet its payment obligations that triggers a settlement under a credit default swap (CDS) contract. CDS contracts are governed by the Master Agreement of the International Swaps and Derivatives Association (ISDA), a trade group representing and promoting the interests of hundreds of market participants "to make the global derivatives markets safer and more efficient."
BREAKING DOWN Credit Event
The three most common credit events, as defined by the ISDA, are bankruptcy filing, payment default and debt restructuring. Three others — obligation default, obligation acceleration and repudiation/moratorium — are infrequent credit events. In the 1980s, the need for more liquid, flexible and sophisticated risk management products for creditors laid the foundation for the eventual emergence of credit default swaps.
A credit default swap is a transaction in which one party, the "protection buyer," pays the other party, the "protection seller," a series of payments over the term of the agreement. The buyer, in essence, is taking out a form of insurance on the possibility that a debtor will experience an event that jeopardizes its ability to meet payment obligations. The purchase of the CDS can be a hedge if the buyer is exposed to the underlying debt of the borrower, but since CDS contracts are traded, a third party could be making a bet that either: a) the chances of a credit event increase, in which case the value of the CDS will rise, or b) a credit event actually occurs, leading to a profitable cash or physical settlement. (Most settlements are in cash.) The seller receiving the series of payments from the buyer would not have to perform settlement of the contract if no credit event arises during the term. It would benefit from all the premium payments from the buyer over the term.