What is Credit Default Swap (CDS)? How Does It Work?

A credit default swap is a financial derivative to swap the credit risk of a debt instrument. It can be used to transfer the default risk of the borrower for any type of debt instrument.

Let us discuss what is credit default swap, how it works, and its pros and cons for all parties involved.

What is Credit Default Swap (CDS)?

A credit default swap (CDS) is a type of financial derivative that protects an investor against the credit risk of the borrower.

The investor transfers the credit or default risk of the borrower to another investor who acts as an insurer in this contract. Thus, a CDS acts like an insurance agreement to protect the investor in a debt instrument.

The buyer of a CDS makes payment to the guarantor against covering the credit risk for the debt instrument. A CDS can be arranged for any type of debt instrument. However, it is more commonly used for junk bonds, collateralized debts, and mortgage-backed securities.

A credit default swap then acts as an agreement between these two parties that if the buyer fails to repay the debt, the seller of the CDS will settle the debt with the lender.

A CDS acts like financial security and is traded on an over-the-counter (OTC) market between different investors. Like any other financial derivative, its price changes depending on different factors including tenor, interest rate, and the creditworthiness of the original buyer.

How Do Credit Default Swaps Work?

Credit default swaps are usually arranged for long-term debt instruments like bonds. A borrower issues a bond or any other debt instrument to raise funds from the market.

The investors provide funds to the borrower against interest and make a fixed income through this investment.

The credit rating of the long-term debt borrowers may change over this long period. The investors may want to protect themselves against the credit risk of the borrower.

Thus, they can buy a credit default swap from a third party. These sellers of the CDSs are usually insurance companies, banks, and hedge funds.

So, there are three parties in a CDS arrangement:

  1. The borrower of the debt is the first party in this arrangement.
  2. The investor or lender is the second party. This party will also be the buyer of the CDS contract.
  3. The third party is the seller of a CDS or insurer against the credit risk of the first party.
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Often investors of debt instruments and CDSs invest for profits rather than offering credit risk protection.

Tenor or Time to Maturity

The tenor or time to maturity of the credit default swap must coincide with the maturity date of the debt instrument. 

The time to maturity and tenor of the CDS should also be the same to easily calculate the yield on both instruments. Thus, secondary market trading would also be possible for both instruments when their maturity dates are the same.

Credit Events

A credit event happens when the buyer of the CDS terminates the contract and settles the payment. A credit event may occur due to different causes such as failure to pay, entity bankruptcy, and obligation acceleration.

How Credit Default Swaps are Settled?

Historically, CDSs were settled physically in the case of a credit event trigger. It means the buyer of the protection would receive a bond from the sellers of the CDSs (if they held the bond with them).

However, CDSs have become regular trading instruments with more sellers offering them as speculative tools.

These days CDSs are settled in cash. Sellers of the CDSs do not hold bonds or debt instruments with them. Also, an increasing number of CDSs are being issued by investors for speculation than hedging.

Therefore, settling CDSs in cash makes more sense and is viable from the operational perspective as well.

A recent development in the settlements of CDSs in the auction process. Credit event auctions are regulated by the International Swaps and Derivatives Association.

In the auction process, credit event participants set a price for the instrument with a cash settlement. Both the sellers and buyers agree to certain terms of the auction process regulated by the ISDA.

Customized Credit Default Swaps

A key point to understand with credit default swaps is their customized formation. Buyers of CDSs can arrange a contract that does not cover the full term of the debt instrument.

For example, if an investor of a bond considers the borrower to remain in financial trouble for the coming five years when the bond’s tenor is seven years, the CDS can be arranged only for five years rather than the full seven years.

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This way, the investor can save on the interest cost and also find protection against the credit risk.

Another key point to remember is that the issuer of the CDS can transfer the credit risk to another party as well. In practice, more issuers of CDSs sell them for speculation these days than hedging.

However, when the credit risk of the original borrower of the debt instrument does not eliminate. The credit risk is transferred from one party to another in this arrangement.

The speculative nature of CDSs means the issuers want to sell these contracts before they mature. If the borrower does not default, the buyer of the CDS would incur the cost of covering the credit risk and without selling the contract, it would not be possible to make profits.

Uses of Credit Default Swaps

Credit default swaps are primarily hedging instruments. However, there are three broader uses of CDSs.

Hedging

Using CDSs as hedging instruments is a common practice among banks. Banks offer loans to corporate entities and may want to hedge their credit risks.

Without using CDSs, banks can trade these debt instruments in the secondary market as well. However, selling after a CDS contract boosts their relationship with the borrowers.

Also, banks may diversify their portfolio credit risk case if their lending instruments are issued to one borrower in a significant proportion.

Banks may also sell CDS contracts to avoid credit events. Investing in a CDS would lose money if the borrower does not default. Hence, selling a CDS is a useful option for banks.

Other institutes like pension funds, hedge funds, and insurance companies also use CDSs as hedging tools.

Speculation

Credit default swaps are financial derivatives and they trade like other derivatives as well.

So, investors can buy a CDS speculating an increase or decrease in the price in the future. Some investors may speculate on the default of the borrower as well.

Conversely, investors may sell a CDS if they think the borrower’s credit rating might improve in the future.

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Investing for speculative purposes works similarly to speculating on stock movements. The investment risks remain and the investors may lose money if they solely depend on the speculative movements of the CDS prices.

Arbitrage

Credit swap spreads and the stock price of the borrower company have an inverse relationship. If the credit rating of the borrower improves, the CDS spread shrinks but the stock price appreciates.

In some cases, two markets may act slightly differently or one may be slow to react. Buying a CDS at a low price and selling it higher in another market is arbitrage.

Arbitrage opportunities can arise in the reverse situation as well when the credit rating of the borrower deteriorates and the CDS spread widens.

Pros and Cons of Using Credit Default Swaps

Credit default swaps come with different advantages and disadvantages for all parties involved.

Pros Explained

The biggest advantage of CDSs is the protection for lenders. Lenders can offer more money to borrowers with credit risk protection through a CDS.

It helps lenders to offer loans to risky borrowers as well. It means borrowers with low credit ratings can obtain financing from lenders with the help of CDSs.

Issuers of CDSs can earn profits through speculations or even when the borrower defaults. Other investors can also earn profits through trading CDSs as financial derivatives.

Also, sellers of CDSs can diversify their investment risks by selling credit swaps for different industries and different buyers.

Cons Explained

The biggest drawback of credit default swaps is their inability to fully mitigate credit risk. If the borrower of the debt instruments defaults on payment, the CDS cannot eliminate the need to repay.

It means one of the parties owning the CDS will eventually need to settle the payment at the end.

Secondly, CDSs remained largely unregulated until recently. These derivatives have notoriously led to an economic recession in 2008.

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