One of the more interesting developments in the world of derivatives is the credit default swap, or CDS. First used by bond investors as protection against nonpayment by the issuer of a bond; today these instruments are used by investors to fine tune their overall exposure to corporate credit, as well as for speculation.
In this article, we're going to first provide a broad definition of a credit default swap. Next, we're going to talk a little bit about how the market works, including the typical structure / characteristics of these contracts. Finally, we'll talk about some of the innovative ways these swaps are used to hedge against certain credit risks, and how speculators take advantage of these contracts too.
A credit default swap, or CDS, is often compared to the concept of buying insurance. Until recently, these contracts were primarily used to reduce the risk associated with holding bonds, promissory notes, loans, and / or commercial paper. With a CDS, there are two parties involved, and the swap entails the transfer of a third-party credit risk from one party to the second.
Fundamentally, the first party in the swap faces credit risk from a third party. The counterparty in this agreement insures against this risk. In exchange for this "insurance," the counterparty receives regular periodic payments, just like an insurance premium.
If the third party defaults on the bond, the party responsible for providing insurance will have to purchase the bond from the insured party. In this way, the CDS can mitigate the risk associated with bonds by transferring credit risk from one party to another without actually transferring the asset. Credit default swaps can mitigate several different kinds of risks such as credit rating downgrades, bankruptcy, as well as default on a loan.
The size of the credit default swap market is large by any measure. The notational amount on outstanding OTC CDS was nearly $30 trillion in 2006 according to the Bank for International Settlements. Information published by the British Bankers' Association indicates these contracts represent over half of the global credit derivatives market. Generally, there are three sectors that make up the marketplace: corporate offerings, emerging market sovereigns, and bank credits.
A contract can reference a single credit or multiple credits. A multi-credit CDS will normally reference a specific portfolio of credits that are previously agreed upon by both the buyer and seller. Credit default swaps can range in maturity from one to ten years, with a term of five years being the most commonly traded.
Within the contract, the buyer agrees to pay the seller a fixed spread. For corporate issues, the spread is paid on a quarterly basis. For example, a contract with a spread of 20 basis points (bps) entitles the buyer to payments of 5 bps each quarter.
In exchange for this quarterly payment, the seller of the contract typically agrees to one of two types of settlement:
Keep in mind that a credit default swap provides protection only against the events agreed to in the contract.
Just like many other financial derivatives, a credit default swap can be used to reduce the risk of an investor's portfolio and / or as a way to speculate on the changes to credit spreads. We're going to finish our article on this topic by briefly describing these two concepts in the sections below.
Most of this article has focused on the use of a CDS as a way to control credit risk. The owner of a corporate bond can simply protect their investment from the risk of default by purchasing a contract on that asset. By buying this "insurance," the investor can hedge, or insulate, themselves from a pre-defined set of credit risks.
On the other side of the contract is an investor willing to speculate. The rewards for speculators come in three forms: the eventual repayment of debt acquired at a discount, the payment of premiums for providing protection, and / or the trading of the asset itself.
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