Credit default swaps are a financial instrument used to transfer and mitigate the risk of credit exposure.
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They are a bilateral contract between the buyer, who purchases protection of the credit risk, and the seller, who provides protection.
Such instruments allow an investor to assume the risk of an asset even if he does not own the asset, or to own an asset but sell the risk to another party.
Credit default swaps are a type of credit derivative that can be used to function as a sort of insurance or hedge against an existing investment. Credit default swaps are the largest type of credit derivative in terms of trading volume.
Credit default swaps (CDS) are purchased to protect against the risk of credit. A CDS can be viewed as a contract involving three parties—the buyer, who purchases protection, the seller, who provides protection, and the third party, whose credit obligation is being insured.
CDS can last for a variable amount of time and cover a specified credit obligation. Often times, an owner of a certain amount of debt (which must be paid by the third party) purchases a credit default swap to cover the risk of the third party defaulting on its debt. It pays the seller a premium relative to the amount of the debt obligation being covered—typically calculated by multiplying the principal amount by a number of basis points—called the spread—whose value is determined by the credit-worthiness of the third party.
If an entity is thought to be more likely to default on its debt, it will have a higher spread than an entity highly trusted to repay its debt. CDS usually provide protection for defaults as well as any credit event, which can be a bankruptcy, the failure of the third party to pay, a moratorium from the government or other source on the debt, or a restructuring of the debt.
In the case of a default or credit event, the seller of the protection pays the buyer the unrecoverable amount of the principle, and the buyer pays the premium, which is usually adjusted for timing of the credit event. For example, the premium of a CDS would be higher if a credit event occurred near the end of the contract period of the CDS than at its beginning.
Credit default swaps, while often used by owners of debt as a form of insurance, do not require the buyer to be the owner of the debt—thus allowing outsiders to bet on the risk of a company to repay its debt. Also, the third party whose credit is essentially being bet on does not have to be notified of a CDS or other credit derivative related transaction.
Here is a simple example of a credit default swap transaction: An investor purchases protection for $100m of debt of Company ABC at a spread of 300bp for a period of 5 years. The premium of this protection would be $100m x 300bp = $3m which would be paid in installments over the 5 year contract period.
The seller of the protection must be willing to cover the losses of the principle debt in the cast of a credit event. Two years into the CDS contract, Company ABC defaults on its debt and is only able to pay 50 cents on the dollar for its debt, an amount equal to $50m. The seller of the protection is obligated to pay the buyer $50m and the buyer is obligated to pay his portion of the premium, which, since the credit event occurred two years into the contract, would be (2/5) x $3m = $1.2m.
The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts—you can visit their website at www.isda.org .