Understanding Credit Default Swaps | PIMCO (2024)

FAQs

How do you interpret a credit default swap? ›

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 default swap (CDS) is a contract between two parties in which one party purchases protection from another party against losses from the default of a borrower for a defined period of time.

The bond owner may buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will fade.

The investor who's buying the CDS pays protection premiums to the third party to assume that risk. If the original issuer defaults, the third party pays; if not, the third party profits from the premiums.

In its most basic terms, a CDS is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, investors buy credit default swaps for protection against a default, but these flexible instruments can be used in many ways to customize exposure to the credit market.

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.

Their chief purpose is to help manage the credit exposure of fixed-income investments between two or more investors. A CDS can allow investors to hedge against unexpected market volatility and other risk factors. Typically, credit default swaps are the domain of institutional investors, such as hedge funds or banks.

Compared to savings accounts and short-term time deposits, 10-year certificates of deposit may offer more competitive interest rates. They're also virtually risk-free and guarantee a specific rate of return. But given the long return horizon, a 10-year CD isn't a good fit for every saver.

Risks of Credit Default Swap

One of the risks of a credit default swap is that the buyer may default on the contract, thereby denying the seller the expected revenue. The seller transfers the CDS to another party as a form of protection against risk, but it may lead to default.

Can anyone buy a CDS? ›

However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs).

The CDS is valued in much the same way as its cousin, the interest rate swap. In an interest rate swap, the exchange of fixed and variable interest cash flows is valued by estimating the amount of the future cash flows in advance.

As the bank is required by law to insure all loans greater than $10,000,000, it purchases a credit default swap at 2% of the insured principal amount. Therefore, the bank pays the CDS seller 4% of the insured principal amount (4% of $80,000,000) every year for the next 15 years.

Notional Value: refers to the face value of the underlying fixed income securities. Reference Obligation: the underlying security against which the CDS provides default protection. Premium: since a CDS functions as a type of insurance, the buyer pays a premium to the seller, typically on a quarterly basis.

Insurance requires the buyer to disclose all known risks, while CDSs do not (the CDS seller can in many cases still determine potential risk, as the debt instrument being "insured" is a market commodity available for inspection, but in the case of certain instruments like CDOs made up of "slices" of debt packages, it ...