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Credit Default Swap (Cds)
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.