Credit Default Swap - CDS

Loading the player...

What is a 'Credit Default Swap - CDS'

A credit default swap is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. In a credit default swap, the buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract. In return, the seller agrees that, in the event that the debt issuer defaults or experiences another credit event, the seller will pay the buyer the security’s premium as well as all interest payments that would have been paid between that time and the security’s maturity date.

A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

A credit default swap is also often referred to as a credit derivative contract.

BREAKING DOWN 'Credit Default Swap - CDS'

Many bonds and other securities that are sold have a fair amount of risk associated with them. While institutions that issue these forms of debt may have a relatively high degree of confidence in the security of their position, they have no way of guaranteeing that they will be able to make good on their debt. Because these kinds of debt securities will often have lengthy terms to maturity, like ten years or more, it will often be difficult for the issuer to know with certainty that in ten years time or more, they will be in a sound financial position. If the security in question is not well-rated, a default on the part of the issuer may be more likely.

Credit Default Swap as Insurance

A credit default swap is, in effect, insurance against non-payment. Through a CDS, the buyer can mitigate the risk of their investment by shifting all or a portion of that risk onto an insurance company or other CDS seller in exchange for a periodic fee. In this way, the buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the debt security. For example, the buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, should the issuer default on payments.

If the debt issuer does not default and if all goes well the CDS buyer will end up losing some money, but the buyer stands to lose a much greater proportion of their investment if the issuer defaults and if they have not bought a CDS. As such, the more the holder of a security thinks its issuer is likely to default, the more desirable a CDS is and the more the premium is worth it.

Credit Default Swap in Context

Any situation involving a credit default swap will have a minimum of three parties. The first party involved is the financial institution that issued the debt security in the first place. These may be bonds or other kinds of securities and are essentially a small loan that the debt issuer takes out from the security buyer. If an institution sells a bond with a $100 premium and a 10-year maturity to a buyer, the institution is agreeing to pay back the $100 to the buyer at the end of the 10-year period as well as regular interest payments over the course of the intervening period. Yet, because the debt issuer cannot guarantee that they will be able repay the premium, the debt buyer has taken on risk.

The debt buyer in question is the second party in this exchange and will also be the CDS buyer should they agree to enter into a CDS contract. The third party, the CDS seller, is most often an institutional investing organization involved in credit speculation and will guarantee the underlying debt between the issuer of the security and the buyer. If the CDS seller believes that the risk on securities that a particular issuer has sold is lower than many people believe, they will attempt to sell credit default swaps to people who hold those securities in an effort to make a profit. In this sense, CDS sellers profit from the security-holder’s fears that the issuer will default.

CDS trading is very complex and risk-oriented and, combined with the fact that credit default swaps are traded over-the-counter (meaning they are unregulated), the CDS market is prone to a high degree of speculation. Speculators who think that the issuer of a debt security is likely to default will often choose to purchase those securities and a CDS contract as well. This way, they ensure that they will receive their premium and interest even though they believe the issuing institution will default. On the other hand, speculators who think that the issuer is unlikely to default may offer to sell a CDS contract to a holder of the security in question and be confident that, even though they are taking on risk, their investment is safe.

Though credit default swaps may often cover the remainder of a debt security’s time to maturity from when the CDS was purchased, they do not necessarily need to cover the entirety of that duration. For example, if, two years into a 10-year security, the security’s owner thinks that the issuer is headed into dangerous waters in terms of its credit, the security owner may choose to buy a credit default swap with a five-year term that would then protect their investment until the seventh year. In fact, CDS contracts can be bought or sold at any point during their lifetime before their expiration date and there is an entire market devoted to the trading of CDS contracts. Because these securities often have long lifetimes, there will often be fluctuations in the security issuer’s credit over time, prompting speculators to think that the issuer is entering a period of high or low risk.

It is even possible for investors to effectively switch sides on a credit default swap to which they are already a party. For example, if a speculator that initially issued a CDS contract to a security-holder believes that the security-issuing institution in question is likely to default, the speculator can sell the contract to another speculator on the CDS market, buy securities issued by the institution in question and a CDS contract as well in order to protect that investment.

Want to learn more about CDS and other swaps? Check out Credit Default Swaps: An IntroductionDifferent Types of SwapsAn In-Depth Look At The Swap Market and The Alphabet Soup Of Credit Derivative Indexes.

RELATED TERMS
  1. Credit Default Contract

    Security with a risk level and pricing based on the risk of credit ...
  2. Loan Credit Default Swap (LCDS)

    A type of credit derivative in which the credit exposure of an ...
  3. North American Loan Credit Default ...

    A specialized index of loan-only credit default swaps (CDS) covering ...
  4. Asset Backed Credit Default Swap ...

    A redit default swap wherein the reference asset is an asset-backed ...
  5. Temporary Default

    A bond rating that suggests the issuer might not make all of ...
  6. Reference Equity

    The underlying equity that an investor is seeking price movement ...
Related Articles
  1. Bonds & Fixed Income

    Credit Default Swaps: An Introduction

    This derivative can help manage portfolio risk, but it isn't a simple vehicle.
  2. Investing Basics

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  3. Investing Basics

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  4. Options & Futures

    Is Your Mutual Fund Safe?

    You might be carrying more risk than you think if your fund invests in derivatives.
  5. Bonds & Fixed Income

    Certificates Of Deposit: Conclusion

    Let's recap what we've learned in this tutorial: Safety is a hallmark of the traditional certificate of deposit (CD) sold by a bank or credit union. Investors seeking a low-risk investment ...
  6. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  7. Forex Education

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  8. Active Trading Fundamentals

    Get Positive Results With Negative Basis Trades

    Capitalize on the difference in spreads between markets with this popular strategy.
  9. Bonds & Fixed Income

    Certificates Of Deposit: Bells And Whistles (Part 2)

    The list of features that CDs offer is long and impressive. We explored a number of the varieties in Certificates Of Deposit: Bells And Whistles (Part 1) and will review some additional complex ...
  10. Bonds & Fixed Income

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
RELATED FAQS
  1. What are some risks a company takes when entering a currency swap?

    Read about the risks associated with performing a currency swap, including counterparty credit risk in the event that one ... Read Answer >>
  2. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  3. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  4. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
  5. Should you calculate Value at Risk (VaR) for counterparty credit risk?

    Learn how value at risk (VaR) may be used to determine the risk of counterparty default for credit default swaps and other ... Read Answer >>
  6. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center