What Is A CREDIT DEFAULT SWAP

What is a Credit Default Swap (CDS)?

 

A credit default swap (a type of credit derivative contract) refers to a financial contract that permits an investor to exchange or swap his credit risk with another investor. The credit swap model allows the transfer of credit risk of fixed income securities between two or more investors. Let's see how the credit default swap works in this example. Investingport lends Mr. Alex the sum of $7000 for a period of 4 months. Investingport becomes worried that Mr. Alex might default in the repayment of the loan and then proceeds to use a credit default swap to swap the risk. To initiate the swap, Investingport purchases a credit default swap from another investor (a bank or an insurance company) who agrees to pay back the loan in the event of Mr. Alex defaulting.

More often than normal, the credit default swap works just like an insurance policy where a fee is being paid to maintain the agreement. By this principle, the buyer of a credit default swap gets some form of credit protection and then the seller of the credit swap gives an assurance of the creditworthiness of the debt security.

There are several forms of credit derivatives and the credit default swap is the most common. According to Investopedia, a credit derivative is a financial asset that allows parties to handle their exposure to risk and may comprise of a privately held or open agreement between the parties in a creditor and debtor relationship. A credit default swap could include bonds (for instance corporate, municipal, market and mortgage-backed bonds) and other types of securities.

There are situations in which a debtor does not default in the repayment of his loan at the set time. In this case, the credit default swap buyer will lose the money he paid for the credit default swap. However, this loss cannot be compared to the that which is likely to occur in a situation where the debtor defaults in his loan payment, and the creditor does not purchase a credit default swap.

Buying a credit default swap

In the process of purchasing a credit default swap, three parties are usually involved:

• ·        The borrower

• ·        The debt buyer

• ·        The credit default swap seller

The borrower simply refers to the institution that issues the security or loans that the debt issuer receives from the original lender. The borrower gives the lender the guarantee that he would repay the loans owed by the debtor in a situation where the debtor fails to pay back his loan in due time.

The debt buyer buys the credit default swap when the parties involved have reached an agreement.

The credit default seller could be a bank or an insurance firm that ensures the debt between the borrower and the debt buyer is being guaranteed.

 

Acquiring credit default swaps can be risky. Investors can buy them over the counter due to their non- standardized nature; and also buy from big banks that would be able to repay the exact value of the debt in the event of a default.