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Credit Default Swap

Definition

A credit default swap is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting.

Credit Default Swap (CDS) is a financial contract whereby the loan is exchanged for another. The swap usually takes place to avoid default of the loan. The new terms also include insurance of the losses that arise due to the swap.

Buyer of the CDS reduces the losses by shifting the risk to the insurance or CDS issuing company. The loss is mitigated in exchange of a periodic fee. Individual that buys the CDS receives credit protection as the issuing company guarantees payment of the loan. Moreover, it helps ensure that the creditworthiness of the debtor who buys the CDS remains intact.

Details of Credit Default Swap

CDS is the most widely used derivative in the financial market. JP Morgan was the foremost financial institution that introduced credit default swap in 1997. Any credit swap transaction involves three parties: an issuer of the original loan, a debtor that can be an individual, a corporation, or a country, and the CDS selling company.

The loan can be in the form of corporate bonds, sovereign bonds or other similar kind of financial security. Company that issues CDS is mostly a financial institution that guarantees debt payment for the buyer. Apart from selling CDS, the issuer company also buys the financial option from other institutions. This is mostly the case when the company thinks there is a low risk of defaulting with a particular CDS buyer.

Credit swaps usually cover the remaining time-to-maturity of a debt from when it was bought. That said, this is not always the case. If after two years of purchasing an 8-year security, the CDS owner believes that the issuing company is about to default, the security's owner may opt to purchase a 5-year term CDS that would offer protection until the fifth year.

Risks of CDS Trading

Trading in CDS is a complex and a risky transaction. The fact that the financial options are traded over-the-counter means that they are unregulated that further increase the risks of the transaction. Other than that, the CDS market is highly speculative in nature.

Speculator mostly buy the CDS contract along with the underlying securities from a debt issuer that they think is about to default in order to receive interest and premium amount. On the contrary, they tend to sell the CDS contract in case they feel the issuer company will not default thereby taking on greater risk.

A large number of financial institutions and individual speculators enter into CDS transaction every day. Sometimes traders even switch the party. For example, a company that initially sold the security believes that the buyer is likely to default; it can sell the contract to another financial institution on the CDS market, and then purchase the security in question as well as the contract with the aim of protecting the investment. Despite the great risk and controversial nature of the investment option, CDS has become a trillion dollar market today with several transactions taking place in the market every day.

Credit Default Swap FAQ

How does credit default swap work?

A "credit default swap" (CDS) refers to a credit derivative agreement between two counterparties. The buyer pays the seller periodically, and also receives a payoff should an underlying financial instrument default or go through a similar credit event.

Why credit default swaps are dangerous?

Credit default swap can be risky because the buyer might not honor the contract, thereby making the seller fall short of the expected revenue. The seller transfers the CDS to another party to protect against risk, but it may result in default.

Can I buy a credit default swap?

You don't need to own bonds to buy a CDS. An huge investor or investment firm can buy a CDS on corporate bonds not its and then receive the value of the CDS if the company defaults—with no risk of losing money on the bonds.

What is credit default swap in simple terms?

A credit default swap (or CDS for short) is an investment type where you pay someone, who will pay you back in case a certain company does not pay its bonds, or defaults. Rules (called regulations) are made by the government to check insurance, but there's none for credit default swaps.

How is CDS spread calculated?

Yearly payments of the percentage of the notional principal–even if the premiums are paid quarterly or semiannually — as a premium is the CDS spread. For example, a CDS buyer paying 50 basis points quarterly has a CDS spread of 200 basis points.

Further Reading


How the subprime crisis went global: Evidence from bank credit default swap spreads
www.sciencedirect.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

Regime dependent determinants of credit default swap spreadsRegime dependent determinants of credit default swap spreads
www.sciencedirect.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

The relationship between credit default swap spreads, bond yields, and credit rating announcementsThe relationship between credit default swap spreads, bond yields, and credit rating announcements
www.sciencedirect.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

Counterparty credit risk and the credit default swap marketCounterparty credit risk and the credit default swap market
www.sciencedirect.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

Liquidity and credit default swap spreadsLiquidity and credit default swap spreads
papers.ssrn.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

Explaining credit default swap premiaExplaining credit default swap premia
onlinelibrary.wiley.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

The determinants of credit default swap premiaThe determinants of credit default swap premia
www.cambridge.org [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

Credit default swap spreads and systemic financial riskCredit default swap spreads and systemic financial risk
www.econstor.eu [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

Informational efficiency of credit default swap and stock markets: The impact of credit rating announcementsInformational efficiency of credit default swap and stock markets: The impact of credit rating announcements
www.sciencedirect.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …

The reaction of emerging market credit default swap spreads to sovereign credit rating changesThe reaction of emerging market credit default swap spreads to sovereign credit rating changes
www.sciencedirect.com [PDF]
… 4 For obvious reasons, those defaults and the growth performance that drives them have major … by spreads in the asset-backed commercial paper market and LIBOR minus the overnight index swap … Fig. 1. Evolution of spreads on credit default swaps (median, in basis points) …



Q&A About Credit Default Swap


How do individuals protect themselves against this risk?

Individuals can protect themselves against this risk by purchasing a Credit Default Swap (CDS).

What does it mean when you say that an individual or corporation has "defaulted" on their loan?

When an individual or corporation defaults on their loan, they have failed to make payments according to the terms and conditions set forth in their agreement with lender(s).

Why did Lehman Brothers go bankrupt in September 2008?

Because of the financial crisis of 2007–08 and subsequent recession, many businesses went bankrupt. Lehman Brothers was one of them.

What is hedging?

Hedging is when investors buy something (like stocks) and then sell something else (like options) based on those same things at different times in order to reduce risk without actually owning anything themselves .

What is a credit default swap?

A credit default swap (CDS) is a financial contract that allows the buyer to exchange the loan for another. The new terms also include insurance of the losses that arise due to the swap. Buyer of CDS reduces losses by shifting risk to issuing company. Losses are mitigated in exchange of periodic fee.

Why would someone want to buy a CDS instead of just buying insurance from an insurance company directly?

Buying a CDS is cheaper than buying direct insurance from an insurance company because there are no upfront costs involved with purchasing one; however, if you purchase direct insurance, you will not be able to sell your policy at any point during its duration.

How does a CDS differ from insurance?

Insurance companies make sure that the people who buy insurance have what they're insuring, but nobody makes sure you have the bonds you get CDSes for. People can speculate on them by buying CDSes on companies they think will get in trouble.

Who were some firms that hedged with credit default swaps ?

Some firms that hedged with credit default swaps included Goldman Sachs , Deutsche Bank , Citigroup , Merrill Lynch , Morgan Stanley , JPMorgan Chase & Co., UBS AG, Societe Generale SA, Credit Suisse Group AG and Barclays Plc .

What happens if I am unable to pay my mortgage and I don't own my home anymore but still owe money on it?

If you cannot pay your mortgage and do not own your home anymore but still owe money on it, then technically you have defaulted on your mortgage and are now in foreclosure proceedings with your bank/lender/mortgage holder. Your lender may choose not to foreclose immediately depending upon how much money they think they could recover through foreclosure proceedings versus selling your property at auction for less than what they could recover through foreclosure

Who buys CDSs?

Individual who buys CDS receives credit protection as issuing company guarantees payment of loan.

What happened when Lehman Brothers went bankrupt?

The insurance company AIG had sold lots of CDSes for Lehman, but they didn't have enough money to pay all the people they had sold them to because so many companies bought and subsequently sold CDSes that when one company goes bankrupt there are not enough funds to cover all claims made against it.

How do investors hedge their investments using credit default swaps ?

Investors can hedge their investments by buying protection against losses on corporate debt through derivatives such as credit-default swaps .