Sunday, 9 August 2015

What is Credit Default Swaps

It is basically an insurance against default.
If A buys credit default swap (CDS) from B, A would pay B some money every month or every year.  In return, B agrees to pay A some money in the case of a default of certain bond or loan specified in the contract.
CDS serves legitimate financial purposes.  For example, if A owns the bond or loan in question, he can use CDS to hedge against the risk of loss in the case of default.  However, some people buy CDS even if they don't have a financial interest in the loan.  It's just a bet that the loan will go bad some day.  This is a pure speculation game.
Let's say you own a firm A. There is another firm B which needs capital to expand but is short of liquid assets. But credit rating of B was poor(let it be B+). You have enough liquid money, so you can lend money to B. But you are afraid of its rating.
Now, another insurance company C(Credit rating of C is better.Let it be AAA.) comes into picture.C assures your money which is being lent to B through an insurance so that you don't worry. In return it charges some interest annually. So, now you can lend your money to B at some higher per cent so that you cover your interest expense.
 This entire process is called credit default swap since the credits are swapped to avoid the risk of default.
Single name CDS is one of the most simplest and popular forms of the derivative. The contract represents a transfer of credit risk between two counterparties, where the buyer of protection pays a regular fixed premium to the seller of protection in return for compensation contingent on the occurrence of a specified credit event (event of default, or other covenant breaches).
In the event of default, a protection buyer can sell any deliverable obligation to the protection seller. The value of the delivered security at the time of the delivery is known as the Recovery. The payout from the CDS protection seller becomes (1 - Recovery). This mechanism ensures that a basis holder (long credit, short credit risk) always recovers par (face value of bond), which was the original intention of the derivatives when they were invented in the 90s to allow banks to hedge their credit portfolios.
The price discovery of the recovery rate is very interesting but shall be saved for a more detailed discussion.

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