Credit default swap also known as CDS is the term that is used in the context of financial markets, it is a type of derivative contract which derives its value from the credit risk associated with borrower defaulting on the loan taken from the lender. In simple words, it is that contract by which one party agrees to swap the risk in return of premium with another party in the event of the default by the borrower, in order to get a better idea about this term one should look at some of the important features of credit default swap –
Credit Default Swap Characteristics
Insurance Tool
In the case of companies, CDS acts as an insurance tool for the companies or individuals buying CDS because in the event of the borrower or issuer of the bond defaulting the purchaser will get his or her funds due to that individual or company has swapped the risk with credit default swap seller. In simple words, just like life insurance provides a fixed payout to the nominees only on the policyholder’s death in the same way CDS provides protection only in the event of default by the borrower.
Fees Payment
In case of a credit default swap, the buyer of the CDS will have to pay a fee or premium to the seller of the CDS for the risks which the seller undertakes in the event of the default happening. In simple words just like put options in case of stock allow investors to hedge against the stock going downwards in the same way credit default swaps allow individuals to hedge against the risk of default of the borrower in exchange of small fees or premium.
Shifting of Risks
In the case of CDS, the risk is not eliminated rather it is transferred or shifted from one party to another party and hence it does not provide complete protection to the buyer of CDS because chances are that even CDS seller can also default making the whole process of credit default swap a risky one. In simple words just like vaccinations provides immunity against viral diseases but do not guarantee 100 percent immunity in the same way CDS provides immunity against default but does not provide complete immunity against default.
Minimum Three Parties
In the case of credit default swaps, there is a minimum of three parties which are involved one is the party which is the borrower and has issued the security to the lender for the credit taken by the borrower from the lender second is the lender who has given credit to the borrower in exchange of the security and is also the CDS buyer and the third party is the CDS seller who has agreed to pay to the CDS buyer in the event of default by the borrower.
Multiple Factors at Play
In the case of credit default, there are many factors that affects the transactions like the credit rating of the instruments issued by the borrower, economic environment prevailing in the market, liquidity available in the market, government monetary and fiscal policies, excepted recovery in the event of the default and many more thus making the credit default swap a complex instrument which can be traded and dealt by professionals and financial institutions who regularly deal in such type of instruments.
As one can see from the above that credit default swaps has some unique characteristics and that is the reason why it is used by individuals as well as companies across the world to mitigate as well as manage the day-to-day counterparty credit risks associated with doing business.