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What are CDSs (Credit Default Swaps)?

A credit default swap, or CDS, is often compared to the concept of buying insurance. And until recently, credit default swaps were primarily used to reduce the risk associated with holding bonds, promissory notes, loans, and / or commercial paper. With a CDS, there are two parties involved, and the swap entails the transfer of a third-party credit risk from one party to the second.

Fundamentally, the first party in the swap faces credit risk from a third party. The counterparty in this agreement insures against this risk. In exchange for this "insurance," the counterparty receives regular periodic payments - just like an insurance premium.

If the third party defaults on the bond, then the party responsible for providing insurance will have to purchase the bond from the insured party. In this way, the CDS can mitigate the risk associated with bonds by transferring credit risk from one party to another without actually transferring the asset. And credit default swaps can mitigate several different kinds of risks such as credit rating downgrades, as well as default on a loan.

Just like many other financial derivatives, a credit default swap can be used to reduce the credit risk of an investor's portfolio and / or as a way to speculate on the changes to credit spreads. We're going to finish up our article on this topic by briefly describing these two concepts in the sections below.

So far the focus is on the use of a CDS as a way to control credit risk. The owner of a corporate bond can simply protect their investment from the risk of default by purchasing a CDS on that asset. By buying this "insurance" the investor can hedge, or insulate, themselves from a pre-defined set of credit risks.

Of course on the other side of the contract is an investor willing to speculate. The rewards for speculators come in three forms, the final repayment of debt acquired at a discount, the payment of premiums for providing protection, and / or the trading of CDS itself.

Debt Repayment - when a company is having financial difficulty, the speculator might be able to buy that company's bond at a discount to par. If the company does pay back the entire debt, then the speculator profits by receiving the difference between the discounted purchase price and the bond's full par value.

Protection - in exchange for providing protection against credit risk, the speculator receives quarterly premiums. If the company does not go into default, or trigger any of the identified credit risks, then the speculator would have received money without having to invest in any security.

Trade in CDS - and finally, a speculator can profit from CDS is through the purchase and sale of outstanding credit default swaps. In the same way that the price of a bond fluctuates as the creditworthiness of a company increases or declines, the price of a swap fluctuates. In fact, the volatility of a swap is much greater than that of the underlying bond. So the credit swap market allows the speculator to realize greater gains, and losses, compared to investing in the bond itself.

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