Financial Terms / C - D / Credit Default Swap

Credit default swap

Credit default swaps (CDS) are financial tools that let you swap or offset credit risk with another investor. They work like insurance for loans or bonds. If you're worried about a borrower not paying back a loan, you can buy a CDS to protect yourself.

Here's how it works: You buy a CDS from another investor. They agree to pay you back if the borrower can't pay. You keep paying small fees, like insurance premiums, to keep the CDS active.

CDS contracts can cover different risks:

Defaults
Bankruptcies
Credit rating downgrades

There are three main types of CDS:

Single-credit CDS: Covers specific companies, banks, or countries
Multi-credit CDS: Covers a custom group of credits
CDS index: Covers a standard group of credits

CDS contracts usually last from 1 to 10 years. The 5-year CDS is the most common.

Why use CDS? They offer several benefits:

Need less cash upfront than buying bonds
Can get exposure to credits not available in the regular market
Can invest in foreign credits without currency risk
Sometimes more liquid than actual bonds

The CDS market is huge, with over $10 trillion in total value. It started as a way for banks to manage risk, but now it's a key part of the credit market.

Remember, CDS are complex tools. They can be used to protect investments or to make speculative bets. Always understand the risks before using them.

How Credit Default Swaps Work

Credit default swaps (CDS) function like insurance for loans or bonds. You buy a CDS from another investor who agrees to pay you if the borrower can't pay. The process involves three main parties: the debt issuer, the debt buyer, and a third party (usually an insurance company or large bank).

Here's a breakdown of how CDS work:

Contract Setup: You enter into a CDS contract, specifying the reference obligation, notional value, premium (spread), and maturity.
Premium Payments: As the protection buyer, you make regular payments to the protection seller, similar to insurance premiums.
Credit Events: If a credit event occurs (like default or bankruptcy), the contract is triggered.
Settlement: The protection seller pays you compensation. This can happen in two ways:
- Cash Settlement: A dealer poll determines the value of the reference obligation. The seller pays you the difference between this value and the notional amount.
- Physical Settlement: You sell an acceptable obligation to the protection seller for its full face value.
Contract Termination: After settlement, the CDS contract usually ends.

The CDS market is huge, with over $10 trillion in total value. It's a key part of the credit market, offering benefits like:

Lower upfront cash needs than buying bonds
Access to credits not available in regular markets
Foreign credit investment without currency risk
Sometimes more liquidity than actual bonds

Remember, CDS are complex tools. They can protect investments or be used for speculative bets. Always understand the risks before using them.

Applications of Credit Default Swaps

Credit default swaps (CDS) have various applications in the financial world. You can use them for risk management, speculation, and arbitrage.

Risk Management

CDS serve as a powerful tool for managing credit risk. As a bank, you might buy a CDS to protect against a borrower defaulting. Insurance companies, pension funds, and other securities holders also use CDS to hedge credit risk. This is similar to buying insurance for your investments.

Speculation

CDS offer opportunities for speculation. You can buy or sell CDS without owning the underlying bonds. This allows you to bet on a company's credit health. For example, you can buy a CDS if you think a company might default. If it does, you'll profit without owning the actual bonds.

Arbitrage

You can use CDS for arbitrage - buying in one market and selling in another for profit. For instance, you might buy a bond and a CDS on the same company. If the prices aren't aligned, you can make money from the difference.

Benefits of Using CDS

Limited cash outlay
Access to exposures not available in cash markets
Invest in foreign credits without currency risk
Sometimes more liquid than actual bonds

CDS are complex tools. They can protect investments or be used for speculative bets. Always understand the risks before using them. The CDS market is huge, with over $10 trillion in total value. It's now a key part of the credit market, offering various ways to manage and profit from credit risk.

FAQs

What exactly is a Credit Default Swap (CDS)?
- A Credit Default Swap, or CDS, acts similarly to an insurance policy. It is a financial derivative that allows the buyer to cover themselves against specific risks, primarily the risk of default. Investors utilize CDSs not only for protection but also to tailor their exposure to the credit market in various strategic ways.
Can you provide a practical example of how a Credit Default Swap is used?
- Consider a scenario where an investor purchases a CDS from AAA-Bank with Risky Corp as the reference entity. In this arrangement, the investor, who is buying protection, agrees to make regular payments to AAA-Bank, the seller of the protection.
How should one understand or interpret a Credit Default Swap?
- A Credit Default Swap is essentially a contractual agreement between two parties—the buyer and the seller. The buyer agrees to pay a premium to the seller in return for protection against the default of a particular credit instrument, like a bond or loan.
What information does the spread in a CDS provide?
- The spread in a CDS is measured in basis points and provides insight into the cost of the swap. For example, a CDS spread of 300 basis points, or 3%, means that to insure $100.00 of a company's debt, an investor would need to pay $3.00 annually. A higher spread typically indicates a greater perceived risk of default by the debt issuer.