Single Name CDSs: Definition and Overview

August 31, 2024 4 min read Finance Investments Credit Default Swaps CDs Financial Instruments Risk Management Derivatives

An in-depth look into Single Name Credit Default Swaps (CDSs), their definition, function, and implications in financial markets.

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Single Name Credit Default Swaps (CDSs) are a type of financial derivative that provide protection against the default of a specific reference entity, such as a corporation or sovereign entity. Unlike other types of CDSs that may cover a basket of entities or indices, Single Name CDSs focus solely on a single entity, hence the term “single name.”

Detailed Definition

Single Name CDSs serve as insurance against the credit risk of a particular issuer. The protection buyer pays a periodic fee to the protection seller in exchange for a payoff if the reference entity experiences a credit event, such as a default. This specific focus on one entity includes higher idiosyncratic risk, which is the risk inherent to the specific entity aside from the market or systemic risk.

Typology

Single Name CDSs can be further categorized based on the type of reference entities they cover:

Corporate CDSs: These are linked to the debt of a specific corporation.
Sovereign CDSs: These cover the risk of a particular country’s debt default.
Municipal CDSs: Focus on the debt of specific municipalities or lower government bodies.

Function and Mechanism

How Single Name CDSs Work

Protection Buyer: This party seeks to mitigate credit risk by paying premiums.
Protection Seller: The counterparty that receives premiums and commits to compensating the buyer in case of a credit event.
Reference Entity: The individual entity whose default or other credit events trigger the swap.

The typical payoff structure is as follows:

\text{Payoff} = \text{Notional Amount} \times (1 - \text{Recovery Rate})

Example

If a corporation, ACME Corp, issues debt and an investor wants to hedge against the risk of ACME Corp defaulting, that investor may purchase a Single Name CDS linked to ACME Corp. If ACME defaults, the protection seller compensates the investor based on the difference between the notional amount and the recovery rate on ACME’s defaulted debt.

Special Considerations

Idiosyncratic Risk

Idiosyncratic risk is particularly significant in Single Name CDSs. This risk is specific to the reference entity and can arise from various factors such as management decisions, regulatory changes, or competitive actions which do not impact other entities in the market in the same way.

Market Liquidity

The liquidity of Single Name CDSs can vary greatly. While some entities may have highly liquid CDS markets due to high investor interest, others may see very thin trading volumes, potentially leading to wider bid-ask spreads and higher transaction costs.

Historical Context

Single Name CDSs gained prominence in the early 2000s as the market for credit derivatives grew. They have played a significant role in both risk management and speculative strategies within fixed income markets. During the financial crisis of 2007-2008, the CDS market, including Single Name CDSs, came under scrutiny for their role in exacerbating the crisis.

Applicability

Use Cases

Risk Management: Investors use Single Name CDSs to hedge against potential defaults.
Speculation: Traders may use these instruments to bet on the creditworthiness of a specific entity.
Arbitrage: Opportunities exist for arbitrage between bond markets and CDS markets.

Comparison with Other CDSs

Single Name CDSs vs. Index CDSs:

Scope: Single Name CDSs cover one entity, whereas Index CDSs cover a portfolio of entities.
Risk: Higher idiosyncratic risk in Single Name CDSs compared to systemic risk in Index CDSs.
Liquidity: Typically lower liquidity in Single Name CDSs compared to broader Index CDSs.

Index CDSs: A CDS that covers a basket of entities, reducing idiosyncratic risk.
Credit Event: A trigger event in CDS contracts, such as a default or restructuring.
Notional Amount: The face value of the loan or asset covered by the CDS.

FAQs

What happens if the reference entity does not default?

If no credit event occurs, the protection buyer continues to pay premiums, and no compensation is made by the protection seller.

Are Single Name CDSs regulated?

Yes, Single Name CDSs are subject to various regulatory frameworks that aim to improve transparency and reduce systemic risk.

How is the recovery rate determined?

The recovery rate is generally determined through a combination of market valuation and negotiated settlements in the case of a default.

References

Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.
Das, S. (2010). Credit Derivatives: Trading & Management of Credit & Default Risk. Wiley Finance.
Stulz, R. (2010). Risk Management & Derivatives. Cengage Learning.

Summary

Single Name Credit Default Swaps are critical tools in modern finance for risk management and speculation. By focusing on the credit risk of a single reference entity, they present unique challenges and opportunities, particularly regarding idiosyncratic risk and liquidity. Understanding the mechanism, benefits, and limitations of Single Name CDSs is essential for market participants involved in credit derivatives.

This comprehensive coverage of Single Name CDSs should inform and satisfy the curiosity of any reader looking for detailed and accurate information on the subject.