Understanding Credit Default Swaps (CDS) and How They Work

Credit Default Swap (CDS): Understanding How They Work and How to Invest

Credit Default Swap (CDS) contracts have become increasingly important in the global credit market.
These derivatives offer investors a flexible solution to manage credit risk associated with various financial assets, from corporate bonds to mortgage-backed securities.

What are Credit Default Swaps?

A Credit Default Swap (CDS) is a derivative product that allows an investor to exchange or offset their credit risk with that of another investor.
In a typical CDS agreement, the “protection buyer” pays a periodic premium to the “protection seller” in exchange for the latter’s promise to reimburse the buyer in the event of a credit event, such as the default of a reference entity.

In essence, Credit Default Swaps act as insurance for the creditor party of an underlying contract.
While designed for protection, the reckless use of CDS in the past played a significant role in the subprime mortgage crisis in America.

How Do Credit Default Swaps Work?

The mechanism of a CDS can be outlined as follows:

• Reference Entity: The CDS is related to a specific reference entity, such as a corporate bond or a government security.
• Buyer: The investor looking to protect against the default risk of the reference entity becomes the buyer (protection buyer).
• Seller: Another party, often a financial institution or an investment fund, takes on the role of the seller (protection seller).
• Periodic Premium: The protection buyer pays a periodic premium to the protection seller for the duration of the contract.
• Credit Events: If a credit event occurs, such as the default of the reference entity, the protection seller is obliged to compensate the buyer for the losses incurred.

This structure allows investors to transfer credit risk without necessarily holding the underlying asset, providing them with greater flexibility in portfolio management.

Types of Credit Default Swaps

The CDS market can be divided into three main sectors:

• Single-name CDS: These CDS refer to specific entities, such as companies, banks, or sovereign states.
• Multi-name CDS: These contracts cover a customized portfolio of reference entities agreed upon by the protection buyer and seller.
• Index CDS: Index CDS offer exposure to a basket of reference entities, often representative of a specific sector or market.

Regardless of the type, CDS contracts can have maturities ranging from 1 to 10 years, with the five-year contract being the most actively traded segment.