Credit Default Swap (CDS)
A credit default swap (CDS) is a type of credit derivative that protects against the risk of default on a loan.
How CDSs Work:
- CDS Buyer: Pays a premium to the CDS seller.
- CDS Seller: Guarantees to pay the buyer if the loan borrower defaults.
- Reference Loan: The CDS is linked to a specific loan or group of loans.
- Credit Events: If the borrower defaults or experiences other specified credit events, the CDS seller pays the buyer.
Types of CDS:
- Protection CDS: Protects against the risk of default on a specific loan or group of loans.
- Credit Protection Fund CDS: Protects against losses in a credit protection fund.
- Index CDS: Protects against losses on an index of loans.
Uses of CDS:
- Risk Management: Hedge against the risk of loan default.
- Credit Protection: Obtain financial protection against potential losses.
- Speculation: Trade on credit market volatility.
Key Features:
- Credit Risk Transfer: CDSs allow investors to transfer credit risk to another party.
- Protection Against Default: They provide protection against losses due to default.
- Predictable Payouts: CDS payments are based on a fixed payout schedule.
- Market-traded: CDSs are traded on organized markets, allowing for liquidity.
- Credit Spread: The spread between the premium received and the cost of protection is the credit spread.
Advantages:
- Protection Against Default: CDSs provide a way to protect against loan default.
- Hedging: Can be used to hedge against credit risk.
- Liquidity: CDSs are traded on markets, providing liquidity.
Disadvantages:
- Cost: CDSs can be costly to purchase.
- Counterparty Risk: The CDS seller’s creditworthiness is important.
- Potential Losses: There is potential for losses if the borrower defaults.
- Market Volatility: CDS prices can fluctuate significantly due to market volatility.
FAQs
What is a credit default swap (CDS)?
A credit default swap (CDS) is a financial derivative contract in which one party (the buyer) pays a periodic fee to another party (the seller) in exchange for protection against the default of a specified debt, such as a bond. If the debt issuer defaults, the seller compensates the buyer for the loss.
How does a credit default swap work?
In a CDS, the buyer pays regular premiums to the seller. If the underlying debt defaults, the seller must compensate the buyer for the loss, usually by paying the debtโs face value or taking ownership of the defaulted asset.
What is an example of a CDS payout?
Suppose a bank buys a CDS on a companyโs bonds. If the company defaults, the CDS seller will pay the bank the amount of the bondโs face value, helping the bank recover its losses.
What is the difference between CDS and CDO?
A CDS is a contract protecting against default on debt, while a Collateralized Debt Obligation (CDO) is a structured financial product made up of pooled debt securities, often subdivided by risk levels. CDS contracts can be used to insure CDO tranches against default.
What are the benefits of using CDS?
CDS allows investors to hedge against default risk, speculate on creditworthiness, and manage credit exposure. They offer a way to protect portfolios and potentially profit from changes in credit risk.
