Credit events are a crucial aspect of a credit default swap, or CDS. For example, holders of Fannie Mae or Freddie Mac bonds may have bought a CDS – in effect a type of insurance contract – which specifies the circumstances under which the CDS seller has either to pay them cash compensation, or perhaps buy their bonds for a pre-agreed price. Such circumstances are known as ‘credit events’ and may include a firm defaulting, or having its bonds downgraded. In addition, ‘force majeure’ clauses specify unusual conditions – such as a war, act of God or nationalisation – under which existing contracts may have to be cancelled and unwound so both parties can be returned to their pre-contractual positions.
• Watch Tim Bennett’s video tutorial: Credit default swaps – should investors be worried?