Credit Default Swap or CDS is a contract which offers a guarantee against the non-payment of a loan. CDS is a financial instrument used for exchanging the risk of debt default.
JP Morgan introduced the first credit default swap in 1995. By the year 2007, the total value of credit default swaps increased to an estimated $45 trillion to $62 trillion. Although, merely 0.2% of the investment companies default, the cash flow is relatively lower than the actual amount.
They usually take place in mortgage-backed securities, corporate bonds, emerging market bonds and local government bonds.
Credit default swap market is unregulated and remains vulnerable to a high degree of speculation given its risky and complicated nature.
How Credit Default Swap Works?
In any agreement which involves credit default swap, a minimum of three parties are involved. The first party is a financial institution which issues a debt security. The debt security can be in the form of bonds or other types of securities.
The second party is the debt buyer who buys a bond/security from the institution.
In most cases, bonds and securities have a fair share of risk associated with them. Though agencies which issue these types of debt are confident in the safety of their financial position, they cannot give any guarantees. These debt securities have broad terms of maturity, spanning over decades, which is why these institutions cannot say with certainty that they will be enjoying a sound position then.
This is where credit default swap comes in effect. It provides insurance to the buyer against the non-payment by the debt issuer. By using CDS, consumer directs a portion or all of the risk to an insurance company or any CDS seller in exchange for a regular fee. The CDS seller is the third party involved in this agreement.
The buyer of the swap gives regular payments to the seller until the contract’s maturity date. In return, the seller agrees that if the debt issuer defaults or experiences any problem, the seller will be held responsible for paying the security’s premium and interest payments which were paid by the buyer till date.
Why is Credit Default Swap used?
They are used to minimize the severity of risk which debt buyers have when they buy bonds or securities from a financial institution. If the debt issuer does not default, the CDS buyer will have lost some of his money (in the regular fee he used to give to the CDS seller) but at least he does not have to worry in case the debt issuer defaults (as the CDS seller has taken the risk) and receives the defualted bonds which will still have a certain value.
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