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Credit default swaps (CDS) are the most widely used type of credit derivative and a powerful force in the world markets. The first CDS contract was introduced by JP Morgan in 1997 and by 2012, despite a negative reputation in the wake of the 2008 financial crisis, the value of the market was an estimated $24.8 trillion, according to Barclays Plc. In March of the same year, Greece faced the biggest sovereign default the international markets have ever seen, resulting in an expected CDS payout of approximtely $2.6 billion to holders. Read on to find out how credit default swaps work and how investors can profit from them.

SEE: What Happens In A Credit Event?

How They Work
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference obligation." A contract can reference a single credit, or multiple credits.

As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction, when the reference entity (the issuer) has a negative credit event. If such an event occurs, the party that sold the credit protection, and who has assumed the credit risk, must deliver the value of principal and interest payments that the reference bond would have paid to the protection buyer. With the reference bonds still having some depressed residual value, the protection buyer must, in turn, deliver either the current cash value of the referenced bonds or the actual bonds to the protection seller, depending on the terms agreed upon at the onset of the contract. If there is no credit event, the seller of protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big losses if a credit event occurs.

Hedging and Speculation
CDS have the following two uses.

  • A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a certain period of time.
  • The second use is for speculators to "place their bets" about the credit quality of a particular reference entity. With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company's bonds. An investor with a negative view of the company's credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event. A CDS can also serve as a way to access maturity exposures that would otherwise be unavailable, access credit risk when the supply of bonds is limited, or invest in foreign credits without currency risk.

An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS. This can be very helpful in a situation where one or several bonds are difficult to obtain in the open market. Using a portfolio of CDS contracts, an investor can create a synthetic portfolio of bonds that has the same credit exposure and payoffs.

While most of the discussion has been focused on holding a CDS contract to expiration, these contracts are regularly traded. The value of a contract fluctuates based on the increasing or decreasing probability that a reference entity will have a credit event. Increased probability of such an event would make the contract worth more for the buyer of protection, and worth less for the seller. The opposite occurs if the probability of a credit event decreases. A trader in the market might speculate that the credit quality of a reference entity will deteriorate some time in the future and will buy protection for the very short term in the hope of profiting from the transaction. An investor can exit a contract by selling his or her interest to another party, offsetting the contract by entering another contract on the other side with another party, or offsetting the terms with the original counterparty. Because CDSs are traded over the counter (OTC), involve intricate knowledge of the market and the underlying assets and are valued using industry computer programs, they are better suited for institutional rather than retail investors.

Market Risks
The market for CDSs is OTC and unregulated, and the contracts often get traded so much that it is hard to know who stands at each end of a transaction. There is the possibility that the risk buyer may not have the financial strength to abide by the contract's provisions, making it difficult to value the contracts. The leverage involved in many CDS transactions, and the possibility that a widespread downturn in the market could cause massive defaults and challenge the ability of risk buyers to pay their obligations, adds to the uncertainty.

The Bottom Line
Despite these concerns, credit default swaps have proved to be a useful portfolio management and speculation tool, and are likely to remain an important and critical part of the financial markets.

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