Default CDS

By: EconomyWatch Content   Date: 29 January 2010

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A Credit Default Swap or CDS is a credit derivative that allows the holder of a security to transfer the risk of default to another party for a fee. Credit default swaps are increasingly being used for hedging and speculative purposes. The hedging option allows the holder of a bond or security to reduce or transfer the risk related to certain events to another party. In case of a default, the party selling the CDS bears the brunt of the negative happening and pays off the value of the bond to the buying party. 

Default CDS and its impact

A CDS contract works like an insurance policy and involves the transfer of the credit risk in municipal bonds, emerging market bonds, mortgage backed securities or corporate debt. The CDS provides the buyer of the contract, who is generally the holder of the bond or security in concern, with protection. The protection is against default, or a credit rating downgrade or any other negative credit event such as a bankruptcy or restructuring. The seller of the CDS assumes the credit risk associated with this bond in exchange for a periodic protection fee that resembles an insurance premium. The CDS contract is not actually tied to the bond or the security but references to it. So, it is called the reference entity.

 

The buyer continues to pay the spread or the fee for transferring the risk to the seller till the end of the contract, the actual happening of the default or any other negative credit event. Once the default or the negative event happens, the payment of annual protection fee stops and the seller of the CDS has to settle the contract. This settlement can be either a physical settlement or a cash settlement depending on the terms of the agreement.

 

In case there is no negative event or default during the contract period, the seller of the CDS continues to receive the periodic fee during the tenure of the contract without paying off any amount to the seller. Perception about the possible default of a bond determines the level of spread on a credit default swap. The spreads or the fees payable to the seller of a CDS increases with the growing possibility of a default or the happening of a negative credit event.

 

 


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