Understanding corporate finance: derivative contracts: credit default swaps
Credit default swap: example
Trushan plc group is a large UK construction group which is part of a consortium engaged in a major building project in a developing country. The group’s finance company, Trushan Finance plc, has made a 5-year loan of $300 million, at a market rate of interest, to the consortium company. Four years remain until the loan matures. Because of political instability in the region, the group begins to be concerned that stage payments on the project might fall into arrear, with the result that the consortium company might default on interest payments on the loan.
Trushan Finance plc hedges the credit risk by entering into a 4-year credit default swap with a commercial bank.
Under the terms of the swap, each time Trushan Finance plc receives an interest payment from the consortium company, it pays a proportion of that interest to the bank. If, for example, the bank demands 0.5%, the company will pay a ‘premium’ equal to interest at 0.5% on the $300 million loan - or $375,000 per quarter ($300 million x 0.5% x 3/12).
In return, the bank undertakes to buy the consortium company debt at face value from Trushan Finance plc (including any unpaid interest) if a specified default event occurs. The default event, or events, will be specified in the derivative contract. It may be an actual default by the consortium company, or a rescheduling of payments, or a reduction in the debtor company’s credit rating below a certain level.
The bank has therefore taken on Trushan group’s credit exposure, in return for a quite substantial stream of payments. In effect, the group has insured itself against any default on the loan to the consortium.