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Credit Default Swap (CDS)



Definition

A Credit Default Swap (CDS) is a financial derivative or contract that allows an investor to ‘swap’ or offset their credit risk with another investor. Essentially, it’s a kind of insurance against non-payment. The buyer of the CDS makes payments to the seller and in exchange receives a payoff if a specified credit instrument defaults or experiences a similar negative credit event.

Phonetic

Credit Default Swap (CDS): Kred-it De-fault Swap (C-D-S)

Key Takeaways

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  1. Insurance Against Default: A Credit Default Swap (CDS) is a financial derivative that provides a form of insurance against the risk of default on debt. Investors use CDS to protect themselves if the issuer of the debt fails to make its payments, thereby defaulting on the debt.
  2. Premium Payments: The buyer of a CDS makes regular premium payments to the seller. In return, the seller agrees to make a payment to the buyer in the event of a default. The size of this payment will usually be the difference between the recoverable and the nominal amount of the debt. This mechanism effectively provides a payout to the CDS buyer to offset the loss from a default.
  3. Transfer of Credit Risk: The fundamental purpose of a CDS is to transfer credit risk from one party to another, without transferring the underlying debt. The buyer of the CDS reduces their credit risk, while the seller, typically a bank or insurance company, takes on the credit risk in exchange for the premium payments.

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Importance

Credit Default Swap (CDS) is a critical financial instrument in the business world because it allows investors to manage and transfer the risk of a borrower defaulting on their loan. Essentially, CDS operates akin to an insurance policy against the possibility of a credit event, like a loan default. It is important because it helps maintain financial stability and liquidity within the markets. If an investor fears that a borrower may default, they can use CDS to mitigate potential losses. Yet, it also introduces a higher level of complexity and potential systemic risk to the financial markets, as seen in the 2008 financial crisis. Consequently, understanding and properly managing CDSs is crucial in preventing large scale financial disruptions.

Explanation

A Credit Default Swap (CDS) is a financial derivative that offers a form of insurance against the risk of default on a loan or other form of debt. Essentially, the primary function of a CDS is to shift the risk of default from the holder of the debt to the insurer of the CDS. This is incredibly useful in increasing the safety and stability of financial markets, as it allows investors and banks to better manage the risk associated with their investments and loans.Consider this: an investor purchases a corporate bond but is worried that the company might default on its payments. To mitigate this risk, the investor also buys a CDS from an insurer, paying a periodical premium. In the event that the company defaults, the insurer of the CDS is obligated to cover the loss, thus protecting the investor. This process also provides an additional advantage for speculators and traders as they can bet on the creditworthiness of an entity without actually holding the debt of that company. Thus, CDSs play a vital role in hedging risk and speculating in financial markets.

Examples

1. AIG Financial Crisis (2008): During the global financial crisis of 2008, the American International Group (AIG), a global insurance corporation, served as an example of the significant role credit default swaps can play in the financial system. AIG had sold credit default swaps on complex mortgage securities to multiple banks. When the housing market collapsed, AIG was unable to pay off the insurance it had sold leading to a liquidity crisis. They couldn’t meet their obligations due to the sharp rise in defaults on mortgages, resulting in a massive bailout by the U.S. Federal Reserve to prevent a wider collapse of the financial system. 2. Greek Government Debt Crisis (2010): The Greek government used credit default swaps as a form of insurance to protect bondholders against the risk of default on its sovereign debt. However, as the probability of default increased and Greece’s financial situation worsened, the cost of credit default swaps rose dramatically. This incident highlighted just how CDS can multiply the impact of a financial crisis.3. JPMorgan Chase’s “London Whale” Incident (2012): Bruno Iksil, a trader at JPMorgan Chase and nicknamed the “London Whale” due to the size of his trades, took large positions in credit default swaps that eventually led to a trading loss of more than $6 billion for the bank. This situation highlighted the inherent risks and potential for significant losses associated with the misuse of credit default swaps.

Frequently Asked Questions(FAQ)

What is a Credit Default Swap (CDS)?

A Credit Default Swap (CDS) is a type of financial derivative or contract that allows an investor to swap or offset his or her credit risk with that of another investor. It’s essentially a form of insurance against default risk of a bond.

How does a Credit Default Swap function?

The buyer of a CDS makes payments to the seller, and in return, the seller agrees to compensate the buyer if a specific loan defaults or other credit event occurs.

Who uses Credit Default Swaps?

Credit Default Swaps are most typically used by banks and investment firms. They might also be used by any company or individual who wants to mitigate or speculate on credit risk.

What is the purpose of a Credit Default Swap?

The main purpose of a CDS is to protect investors from the risk of default. They allow investors to manage if not transfer risk from the buyer of the CDS to the seller.

What are the risks associated with Credit Default Swaps?

Risks associated with CDS mainly come from counterparty risk, which is the risk that the seller of the CDS will not be able to fulfill the payment obligation in case of a credit event. Market risk, liquidity risk, and legal risk are other forms of risk associated with CDS.

Can Credit Default Swaps be traded?

Yes, Credit Default Swaps can be freely traded in over-the-counter markets.

What is a credit event in the context of a CDS?

A credit event refers to a negative change in the credit status of a reference entity. It can include bankruptcy, restructuring or failure to meet payment obligations when due.

How did Credit Default Swaps impact the global financial crisis?

During the global financial crisis in 2008, many institutions found that they were overly-invested in CDS and exposed to high levels of risk. Some failed to make the promised payments, leading to a knock-on effect that created instability in the financial markets.

Related Finance Terms

  • Counterparty Risk
  • Credit Events
  • Collateralized Debt Obligations (CDOs)
  • Default Risk Premium
  • Swap Premium

Sources for More Information


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