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What are Credit Default Swaps?
Credit Default Swaps (CDS) are financial derivatives that allow investors to protect against the risk of default or credit events on a specific debt instrument or credit entity. CDS contracts provide a form of insurance or hedging against credit risk. Here are some key points about credit default swaps:
Structure: A credit default swap involves two parties - the protection buyer and the protection seller. The protection buyer pays periodic premiums to the protection seller in exchange for a promise to compensate for losses in the event of a credit event, such as a default or bankruptcy of a reference entity (e.g., a company, government, or financial institution).
Reference Entity and Obligation: CDS contracts are linked to a specific reference entity or a basket of entities. The reference entity can be a corporate bond, a loan, or any debt instrument. The contract specifies the obligations that trigger a credit event, such as a missed payment, bankruptcy, or restructuring.
Credit Event and Payout: If a defined credit event occurs, the protection seller is obligated to make a payout to the protection buyer. The payout amount is typically determined by the difference between the face value of the debt instrument and the recovery value of the defaulted debt. The recovery value is often estimated using auction processes or market prices.
Trading and Market Liquidity: CDS contracts are traded over the counter (OTC) between market participants, rather than on centralized exchanges. The market for credit default swaps is substantial and serves as a key component of the broader credit derivatives market. However, trading volumes can vary depending on market conditions and the availability of market participants.
Hedging and Speculation: CDS contracts can be used for both hedging and speculation purposes. Investors or institutions that hold credit risk exposure can use CDS to hedge against potential losses. Speculators, on the other hand, may trade CDS to take positions on the creditworthiness of specific entities or to express views on market conditions.
Counterparty Risk: CDS contracts involve counterparty risk, as the protection seller may not be able to fulfill its payment obligations in the event of a credit event. This risk became prominent during the 2008 financial crisis when concerns arose about the ability of some protection sellers to honor their obligations, leading to systemic risks.
It is important to note that credit default swaps have been the subject of regulatory scrutiny and debate due to their potential to amplify systemic risks and the need for transparency in the market. As a result, regulatory reforms have been implemented to enhance transparency and oversight of the CDS market.
Credit Default Swaps are covered in more detail in module 6 of the CQF program.