Credit Default Swap (CDS)

What Is a Credit Default Swap (CDS)?

A Credit Default Swap (CDS) is a financial contract that works like insurance for investors holding debt, such as bonds or loans. It helps protect against the risk of a borrower not being able to pay back what they owe.

Components of a Credit Default Swap

Protection Buyer: The investor who buys the CDS to reduce the risk of losing money if a borrower defaults.

Protection Seller: The entity that sells the CDS and agrees to pay the buyer if the borrower fails to pay back their debt.

Premium Payments: The buyer pays regular premiums (similar to insurance premiums) to the seller for this protection. These payments are usually a small percentage of the debt amount.

Reference Entity: The borrower whose debt is being insured, often a company or government.

Credit Events: The contract lists specific events that trigger the protection, like:

• Bankruptcy: The borrower files for bankruptcy.
• Failure to Pay: The borrower misses a payment.
• Restructuring: The borrower changes the terms of their debt in a way that harms creditors.

Uses and Implications:

Hedging: Investors use CDS to protect themselves against potential losses if a borrower defaults on a bond.

Speculation: Some investors buy CDSs to bet against a company’s ability to repay its debt, even if they don’t own any of the debt.

Arbitrage: Traders may look for price differences in CDS contracts across different markets to make a profit.