Concept for credit default swap – CDS
A credit default swap is a financial derivate. Lenders use it to transfer the risk of default on their lending.
For instance, your little brother approaches you for a loan and you lend him funds. However, you think there is a higher risk of default and you will not be able to recover your funds. So, you want to transfer this risk of default to someone else. In this regard, you approach your father and tell him that I have given a loan to little brother. However, I am afraid that he will not pay back the loan. Then your father says that if your little brother does not repay the loan, I will do so on his behalf. However, I will charge you a fixed amount to presume this risk. So, if you agree with your father’s offer, you just entered into a credit default swap agreement.
It means that the risk of credit default on your loan receivable has been transferred to your father against a fixed payment. And there is a swap of credit risk and fixed payment between you and your father. Hence, we call it a credit default swap or transfer of a credit risk against payment.
So, three parties are involved in the credit default swap process.
- Lender (who wants to transfer the risk of default).
- Borrower (Who might default in the future)
- Swap seller (Third-party who presumes credit default risk against a fixed amount)
In our example above, you were the lender, your little brother was a borrower, and your father was a swap seller.
The detailed concept for CDS
A credit default swap is known as CDS. Credit default swaps are financial derivatives that transfer the risk of default to another party in exchange for fixed payments. We also define CDS as a financial swap agreement in which the seller will compensate the buyer in the event of debt default or another credit event. The seller of CDS insures the buyer against some reference asset defaulting. The CDS buyer makes some payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
Here is what it means by credit default swap.
- Credit default: a credit default is a default or inability to pay back the loan.
- Swapping: the swapping occurs when an investor “swaps” their risk to net getting paid back with another investor or insurance company.
How do credit default swaps work
To swap the default risk, the CDS buyer makes periodic payments to the seller until the credit maturity. In the agreement, the seller commits, if the loan issued by the buyer of the CDS defaults, the seller will pay all the premiums and interest that would have been paid up to the maturity date. However, anyone can purchase a CDS, even buyers who do not hold the loan instruments and have no insurable interest in the loan.
Who buys CDS normally?
An investor or speculator may buy protection to overcome the risk of default on a bond or other debt instruments, regardless of whether the investor or speculator holds an interest in or bears any risk of loss relating to such bond or instrument.
In this way, the CDS is similar to credit insurance, although CDS is not subject to the regulation governing traditional insurance. However, an investor can buy and sell protection without owning the reference entity’s debt. These “Naked credit default swaps” allow the trader to speculate on the credit worthiness of reference entities. CDS can create synthetic long and short positions in the reference entity. In addition, CDS can also use in capital structure arbitrage.
CDS documentation
Most CDSs are documented using standard forms drafted by the international swap and Derivative Association (ISDA), although many variants exist. In addition to the basic, single-name swap, there are basket default swaps (BDS), index CDSs, funded CDSs (also called credit-linked notes), as well as loan-only credit default swaps (LCDs).
Who created the credit default swap?
Credit default swaps are said to be created by Bly, the master of jp Morgan in 1994. They gained the most popularity in the 2000s.
The market size for credit default swaps is more than doubled each year. It was $3.7 trillion in 2003. By 2007, the outstanding credit default swap value stood at $62.2 trillion – more than the total amount invested in the stock market, mortgage, and U.S. treasuries combined. Unfortunately, there was no regulatory framework to regulate the credit default swap, which became a growing concern for an investor?
Credit default swap and 2008 financial crises
This all came to a head during the financial crisis of 2008. While many banks were involved, the Lehman Brothers investment bank stands out as the greatest contributor as it owed $600 billion in debt, $400 billion of which was covered by credit default swaps.
The American insurance group (the bank insurer) lacked the funds to clear the debt of the Lehman brothers. So, the Federal Reserve stepped in to bail out the Lehman Brothers and AIG. Hence, crises was created.
However, it should be noted that a credit default swap is different from insurance. Let’s understand the difference.
How credit default swap is different from insurance
CDS contracts have obvious similarities with insurance contracts because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs. However, there are also many differences, the most important being that an insurance contract provides an indemnity against the losses suffered by the policyholder on an asset in which it holds an insurable interest. By contrast, a CDS does not require insurable interest. Hence, it can be applied to speculative risk as well. In addition to this,
Here are some other difference points:
- The seller of CDS in principal is not a regulated entry. On the other hand, insurance is a highly regulated industry.
- The CDS seller is not required to maintain a reserve to cover the protection sold. On the contrary, insurance companies need to maintain reserves.
- Insurance requires the buyer to disclose all known risk, while CDS do not.
- Insurance manages risk primarily by setting loss reserve based on the law on the large number and actuarial analysis. Dealers in CDSs manage risk primarily using hedging with CDS deals and in the underlying bonds market.
- CDS contracts are generally subject to market-to-market accounting,
- To cancel the insurance contracts, the buyer can typically stop paying premiums, while the contracts need to be unwound for CDS.
Example of CDS
As an example, if an investor buys a CDS from an A.A. bank, where the reference entity is a risky crop. The buyer of CDS will make a regular payment to A.A. bank- (the seller protection fee). If risky crops default on their debt, the investor receives a one-time payment from A.A. bank, and the CDS contract is terminated.
Spread of CDS
The “spread “of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as the percentage of the national amount. For example, if the CDS spread of a risky crop is 50 basic points, or 0.5% (1 basis points=0.01), an investor buying $10 million worth of protection from A.A. bank must pay the bank $50,000.payments are usually made every quarter. So, the payment continues until the CDS contracts expire or the risky crops default.
Conclusion
Credit default swap is a financial derivative. It is used to manage the default risk on loan receivable. The buyer of Credit risk default – CDS has to pay certain amount to transfer the risk. So, if insurable/speculative risk matures, it’s compensated by CDS seller.
