What are Credit Default Swaps (CDS)?
- A Credit Default Swap is an agreement between two parties in which a protection buying party pays a premium to a protection selling party; in return for this premium the protection selling party will pay the protection buying party a specified notional amount if a specified credit event takes place in a specified time period affecting a specific debt instrument (called the reference entity).
- Credit events include bankruptcy, bond default, or debt restructuring.
- Buying a CDS means buying credit protection and paying the premium.
- Selling a CDS means selling credit protection and receiving the premium.
- Physical CDS Settlement: CDS buyer delivers the referenced entity (ex. transfers bond ownership) to the CDS seller and the CDS seller pays the notional amount to the CDS buyer.
- Cash CDS Settlement: CDS seller pays the net difference between the notional amount and the market value of the referenced entity (ex. the defaulted bond may be trading for some small fraction of par on the market).
Advantages of CDS
- Credit default swaps provide a method for investors to independently manage credit risk and interest rate risk on fixed income securities.
- CDS allow investors to profit from credit events without actually holding a short position in the underlying security.
- When the bond market does not offer an investor the desired maturity, currency, and credit exposures, swaps and CDS can be used to create the desired exposure.
- CDS can allow a loan portfolio to transfer credit risk confidentially.
Users of CDS
- Banks: Can use CDS to hedge loan portfolio risk and manage regulatory capital requirements.
- Investment Banks: Can use CDS to hedge the credit risks on bond inventories for bonds in which they are market makers.
- Hedge Funds: Can use CDS to execute strategies.
- Insurance Companies: Sell CDS to generate income and diversify their portfolios (but this can be risky business, ask AIG).
- Investment Managers: Can use CDS to attempt to exploit market mispricings to generate excess returns.
- Corporations: Can use CDS as part of their risk management strategies.