What is a Credit Default Swap?

A credit default swap is a form of credit derivative contract that allows the transfer of default risk of a credit loan between parties. Credit default swap is a swap where the credit exposure of fixed income securities and bonds can be transferred between parties. The buyer of a credit default swap makes payment to the seller who is obliged to compensate the buyer if debt default or other credit risks occur before the maturity date of the contract. Credit default swap is commonly used in market bonds, mortgage securities, corporate bonds and some other fixed income products.

How Does a Credit Default Swap Work?

Generally, risks are associated with fixed income products such as securities and bonds. The risk rate also differs from one products to another depending of their time of maturity. The issuer of such products might not be able to guarantee whether defaults will not occur, especially, if the maturity date is a lengthy time. In cases of securities that are not well-rated, debt issuers are likely to default. A credit default swap is a derivative contract between two parties, the buyer and the seller. As part of the terms of this contract, if the debt issuer defaults, the seller will pay the security's premium and other interests to the buyer.

Credit Default Swap as Insurance

A credit default swap protects parties that purchase it from debt issuer default and some other credit occurrences such as non-payment. A credit default swap is then regarded as an insurance against non-payment because it gives buyers credit protection and guarantees on debt securities. CDS is a financial contract and a type of credit derivative that protects buyers from possible loss that are likely to arise when issuers of bonds or securities default on payment. In a CDS arrangement, risks are shifted to insurance companies or to a CDS seller who then pays some amount periodically. However, if everything goes well with the financial contract, the CDS buyer might lose some money. The more default tendency a debt security has, the more desirable a CDS is.

Use of Credit Default Swap

Three parties are often involved in credit default swap arrangements. The first party is the debt issuer (a financial institution), the second is debt buyer who is also the CDS buyer and the third party is the CDS seller (an investing institution). Every CDS has a maturity date, for instance, a debt issuer can issue (sell) a bond with a $100 premium and a maturity period of 10 years. CDS contracts are risk oriented, in this arrangement, the CDS seller guarantees the underlying debt between the debt issuer and the buyer. CDS sellers offer credit default swaps to holders of security to make a profit. Credit speculation is often prevalent in CDS arrangements, an institutional investing organization can involve itself in credit speculation. Speculators with the opinion that the issuer of a debt has the tendency of default purchase the debt securities alongside CDS contract to protect themselves from losses. Through the contract, they receive their premium and interest but if the issuer does not default till the maturity date, speculators of this kind can lose some of their money.