Describe the concept of 'credit default swaps' (CDS).
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Answer
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:
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.
Mechanism of a CDS
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.
Uses of CDS
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.
