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Credit Default Swap
Describe the concept of 'credit default swaps' (CDS).
Solution
A Credit Default Swap (CDS) is a financial derivative that functions as a type of insurance against the default of a borrower. Essentially, a CDS is a contract between two parties: a protection buyer and a protection seller. The protection buyer pays a periodic fee to the protection seller, who in turn agrees to compensate the buyer if a specified credit event, such as a default, bankruptcy, or restructuring, occurs in relation to a third-party borrower, known as the reference entity.
Key Points:
Key Points:
- Protection Buyer: Pays regular premiums to the protection seller.
- Protection Seller: Promises to compensate the buyer in the event of a credit event.
- Reference Entity: The borrower or issuer of debt that the CDS is based upon.
- Premium Payments
The protection buyer makes periodic payments, known as the CDS spread, to the protection seller. These payments are similar to insurance premiums and are typically quoted as a percentage of the notional amount of the reference obligation. - Credit Event
If a credit event occurs, the protection seller is required to compensate the protection buyer. This compensation can be settled in one of two ways:- Physical Settlement: The protection buyer delivers the defaulted asset to the seller in exchange for the face value.
- Cash Settlement: The protection seller pays the protection buyer the difference between the face value of the debt and its market value after the credit event.
- Hedging
CDS are commonly used by investors to hedge against the risk of default by a borrower. For instance, a bank that holds a large amount of a corporation's debt might buy a CDS to protect itself against the potential default of that corporation. - Speculation
Investors can also use CDS to speculate on the creditworthiness of a reference entity. If an investor believes that the risk of default for a particular entity is overstated, they might sell CDS to earn premium payments, betting that a credit event will not occur.- Some risks are involved with speculation as well. The interconnectedness of CDS contracts can contribute to systemic risk. The default of a significant market participant can trigger a cascade of defaults across the financial system. CDS played a notorious role in the 2008 financial crisis. The failure of major institutions like Lehman Brothers highlighted the dangers of excessive risk-taking and insufficient oversight in the CDS market.
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