Collateralized Debt Obligations (CDOs) is the result of rapid expansion in the credit default swap market over the past several years. A default swap is an over-the-counter, privately negotiated contract between a seller and a buyer of credit protection. By writing a default swap, the protection seller provides protection from credit losses to the protection buyer in exchange for a fee. The fee/premium/default swap spread is typically quoted in basis points per year. A company's credit default swap spread is the cost for protection against a default by the company.
The rate of payments made per year by the buyer is known as the CDS spread. Suppose the CDS spread for a five-year contract on XYZ company's credit with a principal of $10 million is 300 basis points. This means that the buyer pays $300,000 per year and obtains the right to sell bonds with a face value of $10 million issued by XYZ company for the face value in the event of a default by XYZ.
If the protection seller includes failure of fulfilling one of its financial obligations. The companies will go through bankruptcy or any restructuring. Note: A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.
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