An option to buy (if a call) or sell (if a put) a prearranged single-name credit default swap (CDS). It gives the buyer the right, but not the obligation, to receive or sell protection on a single name (one reference entity/ asset/ issuer) for a predetermined premium (upfront default insurance cost). The strike price is written on the market value of the underlying CDS at the option’s expiration date.
This option has the effect of triggering the credit event payment when a credit event occurs to the reference entity/ asset during the life of the option. In this event, the protection seller will have to make it good for the protection buyer either physically or by net cash. This coincides with the option automatically knocking out. If no credit event has taken place during the option’s term, the option simply expires without the protection seller being required to make any remedial payment.
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