Introduction to Credit Default Swap (CDS)
Credit Default Swap (CDS) was originally created to provide banks with a means to transfer credit exposure. Credit default swap (CDS) has since grown as an active portfolio management tool and its performance is related to the credit spreads.
What is Credit Default Swap (CDS)?
Credit Default Swap or CDS, introduced by JP Morgan is a contract between two parties— protection buyer and protection seller. The Credit Default Swaps (CDS) are often bought by investors for protection against a default and these contracts are similar to insurance contracts which provide the buyer with protection against risks.
Credit Default Swaps (CDS) are useful in lowering the risk in bond investing by transferring a risk in the bond from one party to another, wherein one party sells risk and another party buys the risk. The seller of the risk owns an underlying credit asset and pays a periodic fee to the buyer. And the buyer pays a decided amount to the seller if there is a default.
In other words, if a credit event occurs in a bond, the protection buyer is fully compensated by the protection seller. On the other hand, if there is no credit event, the protection seller is not liable to make any payment to the protection buyer. This also means that in case of default, the buyer receives the complete face value of the bond or loan from the seller.
Even though the credit default swaps are generally used for hedging credit risks, they can also be held accountable for the financial stability of the economy. Credit default swaps (CDS) are created in a way that they cover many risks like defaults, bankruptcies and credit rating downgrades.
The credit swap market is divided into three sectors—single credit CDS, Multi credit CDS and CDS index. CDS also has many benefits like access to maturity exposure, access to credit risk, investment in foreign credits and liquidity in bonds.
