What is a Credit Default Swap (CDS)?
A Credit Default Swap (CDS) is a financial derivative contract where the buyer pays periodic payments to the seller in exchange for protection against a possible credit event, such as the default or bankruptcy of an issuer. Essentially, the buyer of the CDS receives credit protection, while the seller guarantees the creditworthiness of the debt security or credit profile of another entity.
Key Features
- Protection: In the event of a default, the CDS seller compensates the buyer.
- Premium Payments: The buyer makes regular premium payments to the seller.
- Tenure: The CDS contract is usually maintained over a term of years.
- Settlement: Typically executed through a physical or cash settlement in the event of a credit event.
Examples of Credit Default Swap
- Investor and CDS: An investor buys a CDS from a financial institution to hedge against the default risk of a corporate bond they hold.
- Bank and CDS: A bank selling a CDS might receive regular payments from a fund manager seeking to mitigate the risk tied to a portfolio of loans.
Frequently Asked Questions (FAQs)
What are common uses of a CDS?
CDS are commonly used for hedging, speculation, and arbitrage purposes in financial markets.
What’s the difference between a CDS and a traditional insurance policy?
While both guard against risks, a CDS can be traded in secondary markets, providing more flexibility to investors compared to traditional insurance policies which are typically non-transferable.
How are CDS priced?
CDS pricing is influenced by the perceived creditworthiness of the reference entity and the terms of the CDS contract itself, including the notional amount, premium payments, and term length.
Are CDS regulated?
Following the 2008 financial crisis, CDS markets have seen increased regulation globally, with more stringent reporting, capital, and transparency requirements.
Can anyone buy a CDS?
The capability to purchase a CDS typically requires a higher level of sophistication and financial capacity compared to the average retail investor.
Related Terms
Credit Event
A credit event refers to situations that trigger a payout on a CDS, common examples include default, bankruptcy, or restructuring of the underlying credit instrument.
Reference Entity
The reference entity is the debtor whose default or credit event triggers the CDS contract. It could be a government, corporation, or financial institution.
Premium (Spread)
The regular payment made by the CDS buyer to the seller, typically quoted as a percentage of the notional amount.
Physical Settlement
A type of CDS settlement where the protection buyer delivers the defaulted debt to the seller in exchange for the notional amount.
Cash Settlement
A type of CDS settlement where the protection seller pays the protection buyer the difference between the par value and the market value of the defaulted debt.
Online Resources
- ISDA (International Swaps and Derivatives Association) - Provides a wealth of information about derivative instruments, including CDS.
- Investopedia CDS Definition - A comprehensive overview and detail-oriented articles.
- Moody’s Analytics - Offers insights, analysis, and data on the creditworthiness of entities, impacting CDS markets.
References
- Hull, J. C. (2014). Options, Futures, and Other Derivatives. Pearson Education.
- Choudhry, M. (2006). The Credit Default Swap Basis. Bloomberg Press.
- Gregory, J. (2015). Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives. Wiley.
Suggested Books for Further Studies
- Credit Derivatives: Trading, Investing, and Risk Management by Geoff Chaplin
- Credit Risk Management: The Novel and the Best Practice by Ioannis Akkizidis and Manuel Stagars
- Credit Risk Modeling using Excel and VBA by Gunter Löeffler and Peter Posch
- Structured Credit Products: Credit Derivatives and Synthetic Securitization by Moorad Choudhry
- Credit Derivatives: A Guide for Investors and Bankers by Thomas S. Y. Ho and Sang Bin Lee
