How does a credit default swap work?

May 31, 2022

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Credit Default Swap

A credit default swap (CDS) is a financial derivative instrument that allows investors to protect themselves against the risk of default on debt securities, such as bonds or loans. It is essentially a contract between two parties, known as the protection buyer and the protection seller.

How Does a Credit Default Swap Work?

When a credit default swap is initiated, the protection buyer pays regular premiums to the protection seller. In return, the protection seller agrees to compensate the protection buyer in the event of a credit event, such as a default or bankruptcy, on the underlying debt security.

The credit default swap contract specifies the terms and conditions under which the protection seller is obligated to pay the protection buyer. These terms typically include the reference entity (the issuer of the debt security), the notional amount (the face value of the debt), the maturity date, and the premium amount.

If a credit event occurs, the protection buyer can trigger the credit default swap by notifying the protection seller. The protection seller then has the obligation to pay the protection buyer the agreed-upon amount, which is usually the face value of the debt security minus any recovery value.

It’s important to note that the protection buyer does not need to own the underlying debt security to purchase a credit default swap. This means that investors can use CDS contracts to speculate on the creditworthiness of a particular company or to hedge their existing exposure to credit risk.

Credit default swaps are traded over-the-counter (OTC), which means they are not traded on a centralized exchange. This allows for greater flexibility in terms of contract customization but also introduces counterparty risk, as the protection buyer is reliant on the financial strength and ability of the protection seller to honor their obligations.

Overall, credit default swaps play a crucial role in the financial markets by providing investors with a means to manage credit risk and transfer it to other parties. However, their complexity and potential for abuse were highlighted during the 2008 financial crisis, leading to increased regulation and scrutiny of these instruments.

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