A Credit Default Swap is a swap designed to transfer the credit exposure of fixed income products between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
In other words, A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) undergoes a defined ‘Credit Event’, often described as a default (fails to pay). However the contract typically construes a Credit Event as being not only ‘Failure to Pay’ but also can be triggered by the ‘Reference Credit’ undergoing restructuring, bankruptcy, or even (much less common) by having its credit rating downgraded.
A “credit default swap” (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.
Uses
Credit default swaps can be used by investors for speculation, hedging and arbitrage.
Risk
When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk. Examples of counter party risks:
- The buyer takes the risk that the seller will default. If Derivative Bank and Risky Corp. default simultaneously (“double default”), the buyer loses its protection against default by the reference entity. If Derivative Bank defaults but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.
- The seller takes the risk that the buyer will default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party – that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller.