What is a Credit Default Swap (CDS)?

What is a Credit Default Swap (CDS)?

The term credit default swap (CDS) refers to a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.

Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk.

A credit default swap (CDS) is a contract between two parties in which one party purchases protection from another party against losses from the default of a borrower for a defined period of time.

How Credit Default Swaps (CDSs) Work

A credit default swap is a derivative contract that transfers the credit exposure of fixed income products. It may involve bonds or other related securities—basically loans that the issuer receives from the lender. If a company sells a bond with a $100 face value and a 10-year maturity to a buyer, the company agrees to pay back the $100 to the buyer at the end of the 10-year period as well as regular interest payments over the course of the bond’s life. Because the debt issuer cannot guarantee that it will be able to repay the premium, the debt buyer assumes the risk.

CDSs require at least three parties:

  • The first party is the institution that issues the debt. This party is also known as the borrower.
  • The debt buyer is the second party, who will also be the CDS buyer if the parties decide to engage in the contract.
  • The CDS seller is the third entity involved in the CDS. This entity is most often a large bank or insurance company that guarantees the underlying debt between the issuer and the buyer.

Debt securities often have longer terms to maturity, making it harder for investors to estimate the risk of the investment. That’s why these contracts are an extremely popular way to manage risk. The buyer makes payments to the seller until the contract’s maturity date.

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In return, the seller agrees that (in the event that the debt issuer defaults or experiences another credit event) the seller will pay the buyer the security’s value as well as all interest payments that would have been paid between that time and the maturity date.

  • The credit event is a trigger that causes the buyer of protection to terminate and settle the contract. Credit events are agreed upon when the trade is entered into and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers:
  • Reference entity bankruptcy
  • Failure to pay
  • Obligation acceleration
  • Repudiation
  • Moratorium

Credit default swaps are traded over-the-counter (OTC), which means they are non-standardized and not verified by an exchange. That’s because they are complex and often bespoke. There is a lot of speculation in the CDS market, where investors can trade the obligations of the CDS if they believe they can make a profit.

Uses of Credit Default Swap (CDS)

Investors can buy credit default swaps for the following reasons:

Speculation

An investor can buy an entity’s credit default swap believing that it is too low or too high and attempt to make profits from it by entering into a trade. Also, an investor can buy credit default swap protection to speculate that the company is likely to default since an increase in CDS spread reflects a decline in creditworthiness and vice-versa.

A CDS buyer might also sell his protection if he thinks that the seller’s creditworthiness might improve. The seller is viewed as being long to the CDS and the credit while the investor who bought the protection is perceived as being short on the CDS and the credit. Most investors argue that a CDS helps in determining the creditworthiness of an entity.

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Arbitrage

Arbitrage is the practice of buying a security from one market and simultaneously selling it in another market at a relatively higher price, therefore benefiting from a temporary difference in stock prices. It relies on the fact that a firm’s stock price and credit default swaps spread should portray a negative correlation. If the company’s outlook improves, then the share price should increase and the CDS spread should tighten.

However, if the company’s outlook fails to improve, the CDS spread should widen and the stock price should decline. For example, when a company experiences an adverse event and its share price drops, an investor would expect an increase in CDS spread relative to the share price drop. Arbitrage could occur when the investor exploits the slowness of the market to make a profit.

Hedging

Hedging is an investment aimed at reducing the risk of adverse price movements. Banks may hedge against the risk that a loanee may default by entering into a CDS contract as the buyer of protection. If the borrower defaults,  the proceeds from the contract balance off with the defaulted debt. In the absence of a CDS, a bank may sell the loan to another bank or finance institution.

However, the practice can damage the bank-borrower relationship since it shows the bank lacks trust in the borrower. Buying a credit default swap allows the bank to manage the risk of default while keeping the loan as part of its portfolio.

A bank may also take advantage of hedging as a way of managing concentration risk. Concentration risk occurs when a single borrower represents a sizeable percentage of a bank’s borrowers. If that one borrower defaults, then this will be a huge loss to the bank.

The bank can manage the risk by buying a CDS. Entering into a CDS contract allows the bank to achieve its diversity objectives without damaging its relationship with the borrower since the latter is not a party to the CDS contract. Although CDS hedging is most prevalent among banks, other institutions like pension funds, insurance companies, and holders of corporate bonds can purchase CDS for similar purposes.

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Risks of Credit Default Swap

One of the risks of a credit default swap is that the buyer may default on the contract, thereby denying the seller the expected revenue. The seller transfers the CDS to another party as a form of protection against risk, but it may lead to default. Where the original buyer drops out of the agreement, the seller may be forced to sell a new CDS to a third party to recoup the initial investment. However, the new CDS may sell at a lower price than the original CDS, leading to a loss.

The seller of a credit default swap also faces a jump-to-jump risk. The seller may be collecting monthly premiums from the new buyer with the hope that the original buyer will pay as agreed. However, a default on the part of the buyer creates an immediate obligation on the seller to pay the millions or billions owed to protection buyers.

Pros and Cons of Credit Default Swap

CDS has the following advantages. These swaps protect the buyer against the risk of non-payment by an entity. The cost of such protection is very low. Due to the lower risk, the buyer can invest in riskier investments. This simply means more investment and could push the national economy upwards.

The sellers have a portfolio with a vast diversity of such swaps, which covers the risk of one or more swaps going default. So at the end of the day, they end up making a good profit.

CDS disadvantages are overlooked. The swaps went unregulated for the longest time till 2010. There was no one to ensure whether the seller of CDS had enough reserve money to pay the buyer in case of a default. CDS sellers further mitigate risk by hedging with other CDS deals.