Credit Default Swaps

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Credit Default Swap definition

A credit default swap is insurance against default of a financial security. The protection buyer (investor) pays a periodic, fixed premium to the protection seller, which is typically an investment bank or insurance company, to transfer the risk of default. When the probability of default is low, the cost of the CDS is low and vice-versa.

Credit Default Swap example

An investor holds a portfolio of corporate bonds yielding 6% and wants to get protected for the event of default. Rather than incur the expense of liquidating the portfolio, it is more efficient to protect his portfolio by purchasing a 1-year protection. The investor will buy a 1-year credit default swap by paying a premium (insurance premium) of 2% to keep the principal safe in the event of default over the next 1-year. If there is no credit event, like the default during the life of the swap, insurance premiums will be paid from the investor to the protection seller. If a credit event occurs the protection seller is obliged to make a payment to the protection buyer.

How Credit Default Swaps work

There are two broad types of credit default swaps, sovereign credit default swaps (SCDS) and corporate credit default swaps.

Sovereign Credit Default Swaps (SCDS) are simply CDS for a sovereign country. SCDS offer protection against the default risk of a country’s sovereign bonds. Sovereign CDS spreads can be used to read the market’s expectation of the credit worthiness of a country. If a country’s CDS deteriorates dramatically over a short period of time, you should avoid investing in that country’s stocks, bonds and currency.

Corporate Credit default swaps are CDS for a corporation. Corporate CDS offer protection against the default risk of a corporations’ corporate bonds. Corporate CDS are used to read the market’s expectation of the credit worthiness of a corporation.

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