Credit Default Swap-Protecting Negative Credit Events

A CDS or Credit Default Swap is a contract in which the credit risk pertaining to mortgage backed securities, municipal bonds, corporate debt or emerging market bonds is transferred between 2 entities. In CDS, if you own the credit and if you have bought the contract, you are protected against default or any other credit event that is negative. It is similar to an insurance policy where the insured or the buyer of the policy gets protection.

The selling entity of credit default swap or CDS takes on the credit risk. In return, the seller takes a protection fee from the buyer of the contract. It is more or less similar to the premium you pay to the insurer for extending adequate coverage to you in the event of emergency. Either multiple credits or single credit can be referenced by a CDS contract.

In other words, if you buy CDS, you will get protection in case there is an instance of negative credit event. Under such circumstances, the seller of the credit default swap or the entity that takes on the risk will be paying the buyer. Depending on what terms and conditions were agreed upon between the buyer and the seller of the CDS at the time of the signing of the agreement, the seller can either give cash as per the existing value of the referenced bonds or give the bonds to the buyer.

In case no negative credit event occurs, the buyer of the credit default swaps continues paying the protection fee to the seller. The seller in turn continues receiving the fees and earns profit if there are no instances of credit defaults.

How to trade CDS?

CDS are traded regularly. Depending on the probability rate of having a credit default, the value of the contract is determined. If the seller finds that the buyer has a high probability of a negative credit event, the value of the contract is high. On the contrary, if it is found that the probability of a credit default is low, the cost of the contract also gets reduced. Credit default swap is suitable for organizations. It may not be suitable as a retail investment vehicle. CDS are usually traded OTC or Over-the-Counter. A thorough knowledge of the market is essential as the values are linked to the underlying assets.

What are the risks involved in CDS?

Trading of credit default swap is highly unregulated. There are times when the contracts are so frequently traded that it becomes difficult to figure out the buyers and the sellers. There is another risk and it is quite possible that a seller of the contract may not be in a position to take on the risk. This in turn makes it difficult to assess the value of the contract. Several instances of default were reported with a downturn in the financial markets. Therefore, it makes these contracts quite risky. Despite these drawbacks, CDS are tools for effective speculation as well as portfolio management.