CDS, CDSs: Credit Default Swap

By: EconomyWatch Content   Date: 29 January 2010

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A Credit Default Swap or CDS allows the holder of a fixed income security to transfer the credit risk portion of that security to another party for a fee. A CDS offers a security holder protection against any negative events such as the bankruptcy of the company that is issuing the security or in case the credit rating dips. The CDS is widely used for hedging and speculation purposes and its unregulated nature makes it highly risky.

Understanding the CDS

A credit default swap is a type of insurance in which the buying party is called the buyer. The selling party is called the seller and the security being insured is known as the reference entity. In case of a negative credit event or a default, the seller will either assume the reference entity or pay the buyer the par value of the security. In some cases, the seller may pay the difference between the par value and the recovery amount which is the current cash value of the bond or the security.

Credit Default Swaps (CDSs) are credit derivative products that allow the security holders to manage their credit risk without actually selling the bond. Buying CDS insurance enables the security holders to either exit the bond holding totally or reduce it to some extent.

Remember, CDSs are increasingly used for speculative purposes. Speculators, who believe the credit worthiness of a security is sound, move ahead and sell CDS contracts. They collect premiums which they do not believe they owe on. Similarly, the investors who believe that their security is risky can take on a CDS and earn good returns in case of a negative credit event. CDSs are actively traded and their prices change in response to changes in investor expectations about the credit quality of the reference entity.

CDS vs Insurance

A major difference between a CDS and insurance is that an insurance contract provides indemnity against the losses actually suffered by the policy holder while the CDS offers an equal payout to all holders. The payout in case of a CDS is calculated by using an agreed method.

While insurance contracts involve disclosure of all the risks involved, there is no such requirement in the case of a CDS resulting in many unknown risks. Another major difference is that unlike insurance companies, the CDS sellers are not required to maintain any capital reserves to guarantee the payment of claims.


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