Credit Default Swap Meaning and Explanation

Also known as a CDS swap, a credit default swap refers to a specific type of derivatives used by the buyers to prevent the risk of default and other financial threats. We have some bright credit default swap examples that took place during the economic crisis back in 2008. Today, they represent an agreement where sellers take full responsibility for paying the buyer all interests and premiums in case of the issuer’s default.

In this article, we will have a closer look at CDS swap along with some real-life examples and ways it can be used in the financial market. Besides, we are going to discuss major risks that come with credit default swaps specifically for the purchaser.

What Is Credit Default Swap?

When one buys CDS swaps, he or she agrees on paying a specific sum over a certain period until the credit meets the maturity date. As stated earlier, the agreement also obliges a seller to repay all interest rates and premiums in case of a default.

In other words, it is a tool that makes it possible for the buyer to keep risks under control. It works mostly the same way as insurance plans. You pay for protection over and over to prevent potential risks or unlikely events that may lead to significant losses.

Credit default Swap Example

CDS swaps made their debut back in 1994. Blythe Masters was the first to introduce them to the financial market. However, they became popular only during the financial crisis in 2008 when there were no legal instruments or frameworks to regulate swaps. At that time, CDS swaps stood at $62.2 trillion but a few years later dropped by more than 50%.

Reasons for Investors to Buy CDS

Investors may have various reasons to obtain CDS. And they do not always refer to financial protection or loss prevention. After all, all financial market participants have the one and only goal, which is to make a profit. Considering this, investors can buy credit default swaps for:

1. Speculating. A simple strategy of buying an asset and selling it at a higher price. Investors generally purchase CDS to protect themselves from declined creditworthiness of the issuer or specific company. At the same time, it is possible to sell the protection to another buyer in case you are sure that the company’s or seller’s creditworthiness is going to improve. As a result, CDS can be used as another tool to evaluate the level of entity creditworthiness.
2. Arbitraging. The technique describes the way of buying and selling an asset simultaneously in different markets. The main mission is to make a profit from the short-term temporary price difference. The connection with CDS is quite simple. If the stock price goes up, credit default swap is becoming tighter and vice versa. When a company does not seem to have chances for improvement, CDS becomes wider, and the price of stocks drops.

Hedging. Hedging strategies are utilized as another form of insurance. They help investors to protect their capital from unexpected price movements. This is where banks or other financial organizations may enter CDS agreements as buyers to prevent the risk of borrowers’ default. Besides, credit default swaps make it possible for banks to achieve diversification without ruining relations with loanees.

CDS Swap Risks

The major risk of entering CDS is the possibility for the buyer to default. When a purchaser drops from the agreement, a seller has nothing to do but to look for another buyer or try to sell a news swap to another party, as the only way to recoup initial costs and investments. As a rule, new credit default swaps are sold at lower prices leading to losses.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.