credit default swap (2024)

FAQs

How do credit default swaps work? ›

Credit default swaps insure a loan or bond in case of default. They allow the CDS buyer to transfer the credit risk of the underlying asset to another party. Buyers make periodic payments to the seller, typically quarterly or monthly until the contract's maturity (end) date or until a credit event is triggered.

Yes, it is still legal for investors who do not own the corresponding bonds/assets to buy credit default swaps (CDS). CDS are a type of credit derivative that allow the transfer of credit risk from one party to another, and they are the most common type of credit derivative.

Credit default swaps played a large role in the financial crisis of 2008 for many of the same reasons described above. Large banks which traded in CDS's were forced to declare bankruptcy when a large number of the underlying credit instruments defaulted at once, sending shockwaves throughout the United States economy.

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection.

If a party buys a CDS, it might fail to make all the payments associated with purchasing this contract. In order to recoup this lost income, the party that sold the first CDS could sell a new one to a different party.

Banks may hedge against the risk that a loanee may default by entering into a CDS contract as the buyer of protection. If the borrower defaults, the proceeds from the contract balance off with the defaulted debt. In the absence of a CDS, a bank may sell the loan to another bank or finance institution.

While credit default swaps offer the advantages above, they also come with several downsides: Counterparty Risk: One of the primary downsides of CDS is the exposure to counterparty risk. If the seller of the CDS defaults or fails to fulfill its obligations, the buyer may incur significant losses.

In other words, the price of a credit default swap is referred to as its spread. The spread is expressed by the basis points. For instance, a company CDS has a spread of 300 basis point indicates 3% which means that to insure $100 of this company's debt, an investor has to pay $3 per year.

Credit Event Triggers

The majority of single-name CDSs are traded with the following credit events as triggers: reference entity bankruptcy, failure to pay, obligation acceleration, repudiation, and moratorium.

Recently, another big investor made headlines for his “Big Short” through his purchase of credit default swaps. Bill Ackman turned a $27 million investment in CDSs into $2.7 billion in a matter of 30 days, leading some people to refer to it as the greatest trade ever.

Who owns credit default swaps? ›

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk – who also tends to own the underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event).

Typically, credit default swaps are the domain of institutional investors, such as hedge funds or banks. However, retail investors can also invest in swaps through exchange-traded funds (ETFs) and mutual funds.

Market Liquidity

Credit default swap contracts allow market participants to take long or short positions on a reference entity's creditworthiness without owning the actual debt. This increased liquidity benefits the market, allowing for smoother transactions and pricing mechanisms.

Valuation of a CDS is determined by estimating the present value of the payment leg, which is the series of payments made from the protection buyer to the protection seller, and the present value of the protection leg, which is the payment from the protection seller to the protection buyer in event of default.

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk – who also tends to own the underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event).

A credit-linked note work as a structured finance product that allows a company to transfer the specific credit risk of a fixed-income instrument to a group of investors. The company buys bonds from another company and creates an underlying portfolio of these bonds.