Credit Default Swap
What is a Credit Default Swap (CDS)?
A credit default swap (CDS) is a credit derivative product which allows the holder of a fixed income security to transfer the credit risk portion associated of that security on to a counterparty for a fee. A credit default swap is basically an insurance premium that a security holder pays to guarantee themselves against negative credit events such as bankrupcy or credit rating downgrades. The party buying insurance is known as the buyer, the party providing the insurance is the seller, and the security that is being insured in the transaction is known as the reference entity.
In the case of a default or other negative credit event, the seller will either assume the reference entity and pay the buyer par value or pay the buyer the spread between the par value and the recovery amount, which is nothing more than the current cash value of the bond.
How are CDS Instruments Used?
Credit default swaps are used for one of two reasons, hedging or speculation.
CDS's allows bond holders the ability to manage their credit risk without having to sell their bonds outright. Some investors may want to reduce their exposure to the bond or just get out of the bond to eliminate credit risk for a certain period of time. In either case, buying CDS insurance offers as an alternative hedge to doing either of those two options.
This method of trading credit default swaps has become the most prevalent in recent years. Very similar to an options contract, the CDS allows speculators who believe that the credit worthiness of the reference entity is sound to sell CDS contracts and collect premiums which they do not believe they will owe on. Conversely, an investor who believes that the credit worthiness of a company is failing can enter into a CDS contract as a buyer and reap huge rewards if the entity has a negative credit event.
In reality, CDS's are actively traded, just as option contracts are. Their price fluctuates as investor expectations for the reference entities' credit quality changes.
Risks with Credit Default Swaps
This market is basically unregulated and being that there is no transparency as to who is on the other side of the transaction, it can become very risky when it comes time to fullfill the sellers obligation. There is massive leverage in this market which adds to the risk associated to the seller of the CDS. Let's take even the largest bond insurance companies for example. Ambac, which was considered the leading insurer, has come under heavy pressure as the US credit markets started tumbling in 2007 to 2008. Their stock has dropped dramatically and has investors questioning whether or not their default obligations can be met.
With the recent advent of synthetic CDOs, which is a conglomeration of multiple CDS contracts, the risk has gone sky high. Synthetic CDOs assume the risk for multiple CDS contracts which the investors of the CDO may or may not be able to make good on. The reason for this is that the investors of the CDO have contributed far less capital to the CDO than would be required to fullfil the aggregate default obligations.