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Loan Credit Default Swap (LCDS)

Candlefocus Editor

A loan credit default swap (LCDS) is a credit derivative instrument in which one counterparty has the ability to exchange the credit risk of a syndicated secured loan from one party to another in return for premium payments. Credit default swaps are financial instruments used to transfer the risk of default on a loan from one party to another without transferring the underlying asset. The loan credit default swap operates in much the same way as a standard credit default swap, but with the key difference being that the reference obligation underlying the contract must be a syndicated loan protected by a security such as a liens or a pledge of assets.

Under a loan credit default swap, the buyer (protection buyer) of the LCDS pays a premium to the seller (protection seller). In exchange, the seller makes periodic payments to the buyer should the loan underlying the reference obligation defaults. Generally, payments made to the protection buyer are set at a predetermined fixed rate, although variable or floating rate payments are also possible.

The long-term payment rates of LCDS are determined by the buyers and sellers at the time of entering the contract and will depend upon the creditworthiness of the reference loan. Should the loan on which the LCDS is based upon default, the buyer may initiate a 'credit event' and the payment of the default amount to the buyer will be made based on the terms of the LCDS.

Given that a loan credit default swap allows for the transfer of synthetic default risks, LCDSs are often used by banks to manage their credit exposure. These contracts can help protect the buyer from the risk of any losses due to loan defaults. In addition, LCDSs may be used as a form of insurance against loans that are nearing maturity or are viewed as being at high risk of default.

Overall, LCDSs are a commonly used tool in the credit markets, allowing for the transfer of credit risk to and from different counterparties. The terms of these LCDS contracts are carefully negotiated in order to determine the amount of the payment that will be received by the buyers and sellers should the loan underlying the reference obligation default.

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