The credit default swap (CDS) is a type of credit derivative product. Credit derivatives provide transferring credit risk, which is the possibility that one of the contract parties will not able to fulfill his obligations, from one contractor to another one. Accordingly, credit derivatives are the tools that help banks, financial institutions and investors manage this risk. For example, if a debtor cannot pay the debts, losses will occur on the investments and these losses can be compensated by credit derivatives. Banks and investors prefer credit derivatives over insurance contracts because of their low transaction costs, quick payments and more liquidity. Within this context, CDS could be considered as an insurance transaction that is made to guarantee the receivable of the creditor. The cost of this insurance is the spread determined by the CDS rates. 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. The higher the risk of debt, the higher the CDS point is. The increase in CDS rates indicates that the risk of the debt or the economy has increased. Thus, beyond the insurance function against the default risk, CDS provides insight into the countries’ risks. Especially foreign investors primarily analyze the CDS of the country while they are making an investment in that country.
Published in Chapter:
Valuation of Logistics Hubs: A Case Study From Turkey
Musa Gün (Recep Tayyip Erdogan University, Turkey)
Copyright: © 2020|Pages: 28
DOI: 10.4018/978-1-7998-1086-5.ch015
Abstract
Logistics structures playing significant roles in the economic development of countries are irreversible investments. The exact valuation of them could be difficult due to various uncertainties and problems. This chapter illustrates a methodological way to be able to make an investment decision about the creation of a logistics hub in Of-Iyidere region. Under given assumptions, the study findings indicate that (1) the investment has a positive net present value under three different cost of capital rates, which are 7.5%, 10%, and 15%; (2) the internal rate of return is 18.5%; (3) the payback period is 7 years 8 months; and (4) the discounted payback periods are calculated as 10 years 1 month, 11 years 3 months, and 14 years 11 months according to the aforementioned cost of capital rates. Moreover, the chapter discusses basic project valuation challenges and presents solutions to improve the practice of logistics hub appraisal. So, the paper exhibits an essential guidance and policy support tool to highlight the potential of logistics hub infrastructures in Turkey.
FAQs
That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
What is the meaning of credit default swap? ›
Summary. 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.
What does a CDS spread tell you? ›
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.
What is a credit default swap quizlet? ›
Credit Default Swap (CDS) A credit default swap is essentially an insurance contract wherein upon occurrence of a credit event, the credit protection buyer gets compensated by the credit protection seller. To obtain this coverage, the protection buyer pays the seller a premium called the CDS spread.
How do you make money from credit default swaps? ›
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.
Are credit default swaps good or bad? ›
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.
Why would someone buy a credit default swap? ›
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.
What is the payout on a credit default swap? ›
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.
Are credit default swaps still legal? ›
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.
How to price a credit default swap? ›
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.
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.
What is the primary purpose of a credit default swap? ›
The primary use of Credit Swaps is to manage and mitigate credit risk. Buyers of CDS seek protection against the potential default of a particular credit instrument. By purchasing a CDS, they transfer the risk of default to the seller of the contract.
Who paid the credit default swaps? ›
The buyer of a CDS agrees to make periodic payments to the seller.
What is the payoff of a credit default swap? ›
This value can be expressed as a fraction R of the face value of the bond; R is the recovery rate and therefore on notional principal of L the loss is (1 − R)L and this is the payoff from the CDS, i.e., the amount that the seller of the CDS must pay to the buyer either in cash or other bonds depending on the contract.
What is CDS in simple terms? ›
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.
What is a credit default swap for dummies? ›
A credit default swap is essentially an insurance contract against default on a bond or other debt instrument. One party agrees to make periodic payments in exchange for repayment of all financial obligations (i.e., principal and interest) if the issuer defaults.
How do you calculate credit default swap spread? ›
CDS Spread
The Market Spread can be computed as the ratio of the value of the protection leg, to the RPV01 of the contract. cdsspread returns the resulting spread in basis points.
