Credit Default Swap

What is Credit Default Swap?

Credit default swap refers to a contract which provides protection against credit risk. It is a kind of an agreement or insurance that gives assurance to swap an investor’s credit risk with another investor.

Summary

• Credit default swap provides protection against credit risk;
• It includes three parties: first one is institute, second is debt buyer and CDS seller is the third party;
• A credit default swap provides protection to an investor against bond risk and other specific risks.

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Understanding Credit Default Swap

A credit default swap provides protection to an investor against bond risk. It is like an insurance policies, allow buying protection against unpredictable but destructive events. Credit default swap provides protection against the default of corporate debt, bonds and sovereign debt and also used to get protection against credit risk of bonds, collateralised debt and mortgage-backed securities.

Buyer of Credit default swap gets protection against specific risks, investors mostly buy credit default swap to get protection against default, but these instruments also used to exposure to the credit market. Buyer will make payments to the seller periodically; in return buyer will get compensation for any loss cause from a credit event (default) in a reference instrument. In compensation, the buyer will receive the face value of the bond or loan from the seller. From a seller’s point of view, Credit Default Swap is an easy source of money if there is no credit event.

 

Frequently Asked Questions (FAQs)

 

What are the uses of Credit default swap?

Credit default swap is used by investors for the different reasons including:

1. Speculation

An investor purchases a company’s credit default swap with the motive of earning profit from it, credit default swap may be too high or too low and investor used it to enter into trade. Investor mostly buy credit default swap of those companies which are expected to increase its CDS, because increase in Credit default swap indicates low credit worthiness of company and it likely to default. An investor may sell his Credit default swap in case of rise in it.

2. Arbitrage

Arbitrage refers to the practice of purchasing a security at low from one market and sells it on high in another market. An investor enjoy benefit from there difference. Through arbitrage, an investor enjoys benefit by increase in credit default swap which happen when a company’s stock prices decline due to an adverse event. In order to make profit, an investor exploits the slowness of the market.

3. Hedging

Hedging refers to an investment made by investors to reduce the risk of unfavorable price movements. Sometime a bank use hedge against the risk that a loanee fails to pay by entering into a credit default swap. If the loanee default, the bank manages its default with it, in the absence of credit default swap, bank may sell the loan to another finance institute or bank. The bank buys CDS to manage the default risk by keeping loan as part of the agreement. The bank enter into a contract of credit default swap to achieve its diversity objectives without affecting its relation with the borrower as the latter is not a party to the credit default swap contract. Credit default swap hedging is common in other institutes like insurance companies, pension funds and banks with same purpose.

 

What are the merits or demerits of credit default swap?

Talking about the merits of credit default swap, first and most important point will come into our mind that is Credit Default Swaps provide protection to lenders against credit risk. Credit default swap helps its buyers to investment in risky ventures.  Credit default swap provides a stable stream of payments with some risk, companies sell credit default swap to protect themselves with diversification.

• Provide protection against credit risk
• Provide stability in payments

Coming to demerits of credit default swap, there is no government regulated agency that can look into the transactions, or confirm that the seller of credit default swap has enough money to pay at the time of the default. It was unregulated until 2010 and before that it was hard to understand that whether the seller is undercapitalised or not which leads the false information to the bond purchasers.

• It was unregulated until 2010
• Gave false idea to the bond purchasers

 

What are the different characteristics of Credit default swaps?

The credit default swaps become one of the most popular ways to manage the specific risks. The CDS market is divided into three different sectors are as follow:

 

• Single-credit CDS: Single-credit CDS include bank credits, sovereigns, and specific corporates.
• Multi-credit CDS: Multi-credit CDS include a custom portfolio of credits agreed by both the parties.
• CDS index: CDS index includes reference entities.

Credit default swap provide protection against credit risk, settlement terms of credit default swap is decided at the time or the contract. Talking about its common type credit default swap involve exchange bonds at par value, settlement may in a form of cash payment which is equal to the difference of market and par value of bonds. It also includes hedging credit risk which give benefits to the buyer and sellers.

Other characteristics are:

• Need only a certain amount of cash outlay (which is less than cash bonds).
• In cash market, access to maturity exposures is not available.
• Provide access to credit risk with limited interest rate risk.
• Allow investors to arbitrage opportunities.
• Apt tool for portfolio managers to gain exposure to credit.
• Provide protection against credit risk and other specific risks.
• Includes three parties: first one is institute, second is debt buyer and CDS seller is the third party.