CDS: where are we now?  (21 pages)

-We discuss the many changes to the CDS market over the past year, where we are now and the prospects for further changes
- We provide an update on exposures in the CDS market
- We give a primer in which we explain from first principles how CDS contracts work

(excerpt)
Single name CDS
A credit default swap or CDS is a bilateral agreement between two parties to exchange cash
flows based on future events. It is not a security which changes hands like a bond, and it is not
exchange traded like equity.

The buyer and seller of protection agree on the following
􀀗 Reference entity (e.g. Company X)
􀀗 Notional amount (e.g. EUR10,000,000)
􀀗 Maturity date (e.g. 20 December 2014)
􀀗 Annual coupon (e.g. 100bp)
􀀗 Seniority (e.g. senior unsecured)
.......


How CDS are quoted
The price of a CDS contract can be expressed in three different ways: par spread, upfront or
conventional spread (see the second diagram below).

The par spread is simply the fair coupon which would cause the upfront to be zero. When the
market used to trade using fair coupons, the par spread was physically observable. Since the
market switched to standard fixed coupons, the par spread has become a theoretical concept and
only the upfront is physically observable Converting between par spread and upfront is model and
curve dependent and for a given upfront, no two dealers will agree on the exact par spread.
Therefore, par spreads must not be used for quotation purposes.
The upfront is the cash payment which is exchanged at the start of the trade. It excludes
accrued interest and is like the clean price of a bond, except that it may be positive or negative.
High yield names tend to be quoted in upfront terms, so for example if a name is quoted at 5%, this means
that the protection buyer must pay 5% upfront (minus accrued interest) and 500bp per year.