How do Credit Default Swaps Work?

Credit derivatives were created in order to transfer the credit risk inherent in an instrument from one party to another without actually transferring the ownership of these assets. Prior to credit derivatives, there was no mechanism to isolate the credit risk of any financial instrument.

Credit default swaps were amongst the first structured finance derivative products which were created to help mitigate credit risks. Over the years, the market for credit default swaps has exploded and now the total outstanding value of derivative contracts is more than $10 trillion!

In this article, we will have a closer look at what a credit default swap is and how it helps in managing the credit risk in any portfolio.

What are Credit Default Swaps?

The simplest way to describe a credit default swap is by comparing it to an insurance contract. An insurance contract typically has an “insurer” i.e. a person who provides protection as well as an “insured” i.e. a person who seeks protection. This is also the case with credit default swaps.

There are two parties involved wherein one seeks protection and the other provides it. However, they are not referred to as the insurer and the insured. Here, the protection is being sought against different types of credit events viz. bankruptcy, downgrade, and defaults.

As a part of this contract, the person buying the protection owns the underlying asset. However, they pay a premium to the seller of the protection. This premium is paid in lieu of the contractual obligation that the seller will make good their loss if any credit event takes place. The seller of the credit default swap normally does not hold any position in the underlying economy.

Types of Credit Default Swaps

Over the years, many versions of credit default swaps have been introduced into the financial market. The details of some of these versions are as follows:

1. There are single credit CDS securities that can be mutually agreed upon between parties. Single credit means that it only covers the credit risk of a certain corporation, bank, or any entity. For instance, a credit default swap against Goldman Sachs would cover the specific risks arising from the default at Goldman Sachs. Hence, it is called a single credit CDS

2. Just like single credit CDS, there are multi credit CDS also which are available in the market. These contracts do not transfer the risk of only one security. Instead, the transfer of the risk of a group of securities which has been agreed upon between the buyer and seller of protection. For example, credit default swaps can cover the risk arising from the debt of Goldman Sachs, Citibank, Bank of America, and Wells Fargo.

3. The third kind of contract is known as the index CDS. The index CDS is used to trade the risk of default in a predefined index of securities.

Credit default swaps can also be segregated based on their maturity. CDSs can have a duration from one year to a decade. However, the contracts sold with 5 years duration are the ones that are most commonly traded on the exchange.

Benefits of Credit Default Swaps

Credit-default swaps have grown in popularity because there are certain benefits of using them. Some of them have been listed below:

• Credit default swaps help in the isolation of credit risk from other risks. This helps to enlist the services of different parties which specialize in managing these risks. Banks and other financial institutions face more comfortable managing market-related risks whereas the credit risks are transferred to a different group of investors.

• Credit default swaps require very limited cash outlay. A periodic payment has to be made which is only a small fraction of the value of the asset in question.

• The small payment made in the form of a premium helps the bank remove the credit risk from its books. This helps them to free up valuable capital which can then be used to make loans

• There is a vibrant market for credit default swaps. As a result, companies don't need to hold the swaps till maturity. They can easily find another party who is willing to take up their end of the contract. The liquidity provided in these markets is sometimes more than the liquidity of the underlying assets for which these contracts were made!

How Credit Default Swaps are Settled?

Most credit default swaps are settled in one of the two ways mentioned below:

1. The seller of the protection has to reimburse the buyer with the par value of the bonds in case any credit default takes place. This type of settlement is common when the buyer of the protection does not actually hold the underlying security.

2. As per the second method, the seller of the protection will pay the buyer, the difference between the par value and the market value of the bond. This type of contract is taken by people who already have an interest in the underlying bonds.

The bottom line is that over the years, credit default swaps have become one of the most widely used financial derivatives. However, that has also caused many problems. Initially, the products were created to manage risks. However, over time they started being used for speculative purposes and ended up magnifying the risk in the system.