Credit Default Swaps (CDS) - Bundesverband für strukturierte Wertpapiere (BSW) (2024)

FAQs

What is a credit default swap easily explained? ›

A Credit Default Swap is a contract between two parties—the buyer and the seller—where the buyer pays a premium to the seller in exchange for protection against the default of a specific credit instrument, such as a bond or a loan. The seller commits to making payments if a default occurs.

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.

CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, from one investor to another.

The fixed payments made from CDS buyer to CDS seller are customarily set at a fixed annual rate of 1% for investment-grade debt or 5% for high-yield debt.

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).

Risk management and speculation

CDS contracts have another use as well. Some investors use CDS contracts to speculate on the creditworthiness of specific debt issuers. Someone with a positive view of the credit quality of a company, for example, could become a CDS seller to an investor with a negative view.

Credit default swaps are designed to provide protection against fixed-income products. They are legally traded in the U.S. and regulated by the SEC and CFTC. Although they can offer investors protection against default, they also come with high levels of risk and should be used with caution.

Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons.

The biggest risk to CD accounts is usually an interest-rate risk, as federal rate cuts could lead banks to pay out less to savers. 7 Bank failure is also a risk, though this is a rarity.

In this way, the buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the creditworthiness of the debt security. The buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, should the issuer default on payments.

What is the payout on CDS? ›

The CDS Payout Ratio is the proportion of the insured amount that the holder of the credit default swap is paid by the seller of the swap if the underlying asset defaults.

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.

A credit default swap is a financial derivative/contract that allows an investor to “swap” their credit risk with another party (also referred to as hedging). For example, if a lender is concerned that a particular borrower will default on a loan, they may decide to use a credit default swap to offset the risk.

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.

A credit default swap (or CDS for short) is a kind of investment where you pay someone so they will pay you if a certain company gives up on paying its bonds, or defaults.

The person who buys the swap is essentially betting against a financial product (often a bond) in the hopes that it will fail. The buyer pays a certain amount of money each year (similar to an insurance premium).