What is a Credit Event?
A credit event can be considered as a negative scenario that changes the capacity of the borrower to meet their obligations towards making payments. Most common credit events include bankruptcy filings, payment default or restructuring of debt.
Role
A credit default swap is a prime weapon to tackle credit events helps us to transfer or distribute the risk of default. Credit events give rise to agreements signed between the buyer and seller, where the protection buyer will make payment in periodic intervals to the protection seller, which acts as a form of protective measure from scenarios of going complete default. If such a thing happens where the buyer goes default, it will trigger the credit default swap instantaneously. Credit default swap act as a kind of hedging if the protection buyer has exposure to the underlying debts of the borrower.
Types of Credit Events
#1 – Bankruptcy
This is a legal process where an individual or a company can go default, i.e., come to a state where it is no longer in a position to repay back the sum it owes to its creditors. Generally, bankruptcy is filed by the debtor itself or at times by the creditors, which resemble the inability of an individual or an organization to clear its outstanding debt. A company that has gone bankrupt is also termed as insolvent, and similarly, when an individual files for bankruptcy, he is termed as insolvent too.
Bankruptcy is the final option left when the company or the individual has no more option left to survive in the market or repay back its obligations. Thus, when there is payment default arising in the first step and if it’s occurring on a continuous basis, it is crucial for the seller or creditor to keep a watch or act proactively on the debtor to avoid future losses.
#2 – Payment Default
Payment default and bankruptcy are sometimes confused as the same events. Payment default is a scenario where an individual or company faces difficulty to pay their debt in a timely manner or on time. A continuous trend of payment default may lead to bankruptcy or can be considered as a warning signal that the concerned individual or company is moving to a zone of bankruptcy. Bankruptcy is a case where the concerned party is unable to pay the debt in full, whereas payment default is a case where the party is not being able to pay the debt in a timely manner.
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#3 – Debt Restructuring
This is restructuring the payment terms or the conditions of the debt, which can be less favorable to the debt holders. Typical impacts of debt restructuring can be like change in coupon rate, reduction of the principal amount, postponing the payment scheduled dates, increasing the maturity time. There are now specialized third-party agents too who help in restructuring the debt on behalf of a certain percentage of charges in return.
Differences Between Credit Event and Credit Default Swap
A credit event is a scenario, whereas a credit default swap is a transaction to handle the scenario. A credit even arises where there is a sudden change in the capacity of a borrower to repay back its due obligation. This can be because of bankruptcy, payment default, etc.
The credit default swap is a derivative investment that acts as a contract or a signed agreement between two parties, i.e., the buyer and the seller. The protection buyer on periodic intervals makes small payments as a form of protection against going default, and if by any chance the buyer defaults, it instantaneously triggers the credit default swap contract.
Credit default swap may look like insurance, but it is exactly not so. They act more like options because they will more be betting into what a scenario of credit will occur or not occur. A credit default swap is moreover based on the financial strength of the entity issuing the loan or the underlying bond.
Conclusion
Credit events are unavoidable scenarios that every individual or organization might face at some point in time, but proactively mitigating the risk of it by credit default swap investment product is something which helps both the parties to lose the money and go completely default.
It acts as a shield to the seller from facing huge losses if the buyer goes default under certain critical scenarios. A credit event, if handled appropriately with the use of credit default swap, can lead to a win-win situation for both the parties involved.
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