Credit Default Swaps

What is Credit Default Swaps?

A Credit Default Swap (CDS) is similar to an insurance contract, providing the buyer with protection against specific risks associated with defaults, bankruptcy or credit rating downgrades. CDS is the most widely traded credit derivative product. Typical term of CDS contract is 5 years (up to 10-year CDS). CDS documentation is governed by the International Swaps and Derivatives Association (ISDA), which provides standardized definitions of credit default swap terms, including definitions of what constitutes a credit event.

Mechanism
One party sells risk and the counterparty buys that risk. The seller of credit risk - who also tends to own the underlying credit asset - pays a periodic fee to the risk buyer. In return, the risk buyer agrees to pay the seller a set amount if there is a default.

Transaction Diagram

Risk Buyer or

Risk seller or

Source: Credit Derivatives and Synthetic Structures, John Wiley & Sons. 2001

Uses
1 Speculation An investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve.

2 Heging Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt. 3 arbitrage Capital Structure Arbitrage is an example of an Arbitrage strategy that utilizes CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall.

3 arbitrage Capital Structure Arbitrage is an example of an Arbitrage strategy that utilizes CDS transactions.This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall.

Settlement It Can be Either By 1.Physical or 2.Cash