Credit Default Swap (CDS), Collateralized Debt Obligation(CDO)

CREDIT DEFAULT SWAPS (CDS)

This is a contract that provides insurance against the risk of a default by particular company. The company is known as the reference entity and a default by the company is known as a credit event.

The buyer of the insurance obtains the right to sell bonds issued by the company for their face value when a credit event occurs and the seller of the insurance agrees to buy the bonds for their face value when a credit event occurs. The total face value of the bonds that can be sold is known as the credit default swap’s notional principal.

An ABS where the underlying assets are bonds is known as a collateralized debt obligation, or CDO.

The precise rules underlying the waterfall are complicated, but they are designed to ensure that if one tranche is more senior than another it is more likely to receive promised interest payments and repayments of principal.