An option on a credit default swap. It provides the holder with the right, without the obligation, to enter into a credit default swap at a future date. More specifically, the holder is enabled to buy (call) or sell (put) protection on a specified reference entity for a predetermined future time period for a preset spread. The option is embedded with a knock-out feature, allowing it to knock out if the reference entity defaults during the life of the option. Most commonly traded credit swaptions are European style. For non-knock-out swaptions, a credit default will not trigger cancellation, as opposed to the knock-out version. In this event, the holder can take delivery of the underlying long protection CDS at expiration date and exercise his right to receive protection.
Credit swaptions can either be payer swaptions or receiver swaptions. If a payer swaption, the option holder has the right to enter into a CDS where he pays a premium against receiving protection; and, if a receiver swaption, the option holder receives a premium against providing protection. Credit swaptions allow investors to take a view on volatility and to trace the direction of credit spreads.
This swaption is also known as a credit default swaption or a CDS option.
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