What is a Credit Default Swap?
- A Credit Default Swap (CDS) is a form of protection against credit risk.
- CDS is a bilateral contract where by the credit risk of a reference entity (the issuer) is transferred from the protection buyer to the protection seller.
- The protection buyer pays a fixed premium to the protection seller in return for a contingent payment, which compensates the protection buyer from any loss incurred in case of a credit event.
- A negative credit event (default by a third party) is usually pegged to an obligor’s performance on a reference obligation, like a bond or a loan.
- The standard corporate credit events are bankruptcy, failure to pay, restructuring etc.
- CDS documentation is governed by the International Swaps and Derivatives Association (ISDA).
- ISDA Agreement provides standard definitions of credit default swaps terms, viz., reference obligation, credit event, reference entity and premium and so on.
- CDS are traded over-the-counter (OTC). Standardization of CDS has made the credit default swap much more attractive to the customers in spite of being an OTC product.
Fixed income securities are issued by a company to raise debt financing. These are called corporate bonds and usually these bonds have a fixed coupon rate and a fixed maturity period usually 10 to 30 years. The coupon rates can also be variable and can be linked to any interest rate like LIBOR. An investor can subscribe to these bonds directly from the company at the time of initial issue or these can be bought from the secondary market. When an investor buys the bonds then the investor is subject to several kinds of risks as follows:
Interest rate risk
Fluctuations in the market interest rate will affect the market rate of the security. The interest rate and the market rate of fixed income security are inversely correlated. When the interest rate goes up, market rate of the fixed income security goes down and vice-versa.
Currency rate risk
Securities purchased in foreign currency are exposed to risk of fluctuations in foreign exchange rate. This will affect the effective yield of a security.
Issuer default risk
The issuer may default in the payment of interest and / or principal amount if the issuer faces liquidity crisis or files bankruptcy.
Issuer credit rating risk
The credit rating of the Issuer may undergo change and if it is downgraded the market rate of the security also will suffer to that extent.
An investor can take protection against each type of risk. There are hedging instruments available to cover the interest rate risk as well as currency risk. For the interest default or issuer bankruptcy risk the investor can buy protection and this form of protection is known as ‘Credit Default Swap’.