Credit default swaps (CDS) are the most widely used type of credit derivative on the world market and are a powerful force. According to Barclays Plc, the first CDS deal was introduced by JP Morgan in 1997, and by 2012, the market value was estimated at $ 24.8 trillion, despite its bad reputation following the 2008 financial crisis. bottom.
In March of the same year, Greece faced the largest sovereign defaults the international market had ever seen, resulting in holders expected to pay about $ 2.5 billion in CDS. Here’s how credit default swaps work and how investors can profit from them:
How Credit Default Swap (CDS) Works
CDS contracts include the transfer of credit risk between municipal bonds, emerging market bonds, mortgage-backed securities (MBS), or corporate debt. This is similar to insurance in that it provides purchasers of contracts that often own the underlying credit with protection against defaults, credit rating downgrades, or other negative “credit events.”
The seller of the contract bears credit risk that the buyer does not want to bear in exchange for a regular protection fee similar to insurance premiums and is obliged to pay only in the event of a negative credit event. It is important to note that the CDS contract is not actually tied to a bond, but refers to it. For this reason, the bonds involved in the transaction are called “reference obligations”. The contract can refer to a single credit or multiple credits.
As mentioned above, the CDS buyer gains protection or profits, depending on the purpose of the transaction, if the referencing entity (issuer) has a negative credit event. If this happens, the party selling the credit protection and assuming the credit risk must provide the value of the principal and interest payments that the reference bond would have paid to the purchaser of the protection. not.
Because the residual value of the referenced bond is still declining, the protection buyer will either give the protection seller the current cash value of the referenced bond or the actual bond, depending on the terms agreed upon at the beginning of the contract. Must be handed over... In the absence of a credit event, the seller of protection receives a recurring fee from the buyer and benefits if the reference entity’s debt is good throughout the contract period and no repayment is made. However, in the event of a credit event, the contract seller is at great risk of loss.
Credit Default Swap (CDS)
Hedging and speculation
CDS has two main uses. Its first use is as a hedge or insurance policy against bond or loan defaults. Individuals or businesses exposed to many credit risks can shift some of that risk by purchasing protection under a CDS contract. This may be preferable to selling the security altogether if the investor does not want to reduce its exposure and eliminate it, to avoid being hit by taxes, or if he wants to eliminate exposure for a specific period of time. I have.
The second use is for speculators to “bet” on the credit quality of a particular reference entity. It is clear that speculation has grown into the most common function of CDS contracts, as the value of the CDS market is greater than the bonds and loans referenced by the contract. CDS provides a very efficient way to view the credits of a reference entity.
Investors who have a positive view of the credit quality of a company can sell protection and collect the associated payments instead of spending a lot of money on the company’s bonds. Investors who have a negative view of a company’s credit buy protection for a relatively small recurring fee and get a big return if the company defaults on bonds or causes other credit events. can do. CDS can also be useful as a way to access maturity exposures that are not otherwise available, to access credit risk when bond supply is restricted, or to invest in foreign credit without currency risk. ..
Investors can use CDS to actually replicate their fixed income or fixed income portfolio exposures. This is very useful in situations where it is difficult to get one or more bonds in the open market. A portfolio of CDS contracts allows investors to create a composite portfolio of bonds with the same credit exposure and payoffs.
CDS contracts are traded on a regular basis, and the value of the contract fluctuates based on the increase or decrease in the probability that the referencing entity will generate a credit event. As the likelihood of such an event increases, the contract becomes more valuable to the protection buyer and less valuable to the seller. The opposite happens when the probability of a credit event decreases.
Market traders may speculate that the credit quality of the reference entity will deteriorate sometime in the future and they will buy very short-term protection in the hope of profiting from the transaction. Investors terminate their contracts by selling their profits to another party, offsetting the contract by signing another contract on the other side of the other party, or offsetting the terms of the original counterparty. I can do it.
CDSs are more suitable for institutional investors than individual investors because they are traded over-the-counter (OTC), contain complex knowledge of markets and underlying assets, and are valued using industry computer programs.
The CDS market is not regulated by over-the-counter derivatives, and contracts have too many transactions, making it difficult to know who is standing at both ends of a transaction. Risk buyers may not have the financial strength to comply with the terms of the contract, making it difficult to evaluate the contract.
The leverage associated with many CDS transactions, and the widespread recession in the market, can cause massive defaults and challenge risk buyers’ ability to pay their obligations, increasing uncertainty.
Despite these concerns, credit default swaps have proven to be useful portfolio management and speculative tools and may continue to be an important and important part of financial markets.