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The idea of buying “insurance” or “protection” against counterparty default is quite an old one. Bond insurance or financial guaranty insurance was introduced by American Municipal Bond Assurance Corp or AMBAC in 1971 (Milwaukee Sentinal, 1971). Municipal bond insurance is a type of insurance in which the bond insurer guarantees the interest and principal payments on a municipal bond. A number of bond insurance companies were created and they became known as monolines as they did not have other lines of insurance business. Bond insurance was a generally successful business but after the development of structured credit derivative products many bond insurers entered the credit derivatives market leading to significant losses. Ambac filed for protection from creditors under chapter 11 on 8 November 2010 (Ambac, 2010).

Credit default swaps offer the main means by which credit protection can be bought and sold, and as such are the primary mechanism for CVA trading desks to hedge out credit risks. Physically settled single name CDS contracts pay out the notional amount in exchange for a defaulted bond, although cash settled variants that pay

on default are also available. Hence, single name CDS provide a means of directly protecting a notional amount against the default of a specific counterparty. There are some complications in that the CDS is triggered by a number of specific default conditions and that some, like voluntary restructuring, are typically excluded. This means that the CDS does not always pay out when losses are taken. The Greek sovereign restructuring provides an example of this where the initial voluntary debt exchange did not trigger the sovereign CDS, only the later use of a ‘collective action clause’ triggered the CDS as it involved an element of coercion (Oakley, 2012).

CDS trade only a limited number of reference names and so in many cases buying single name CDS to hedge CVA is not possible. CDS indices such as the iTraxx and CDSIndex Company series can provide an alternative. These are liquidly traded indices which include a basket of underlying CDS contracts. They respond to changes in underlying perceptions of creditworthiness in the underlying basket of names and hence can be used to hedge general sensitivity to CDS spreads. Usually the members of a CDS index are also traded through the single name CDS market. CDS and CDS indices are discussed in Chapter 4 and active management of CVA in Chapter 22.