How Credit Default Swaps (CDS) Work

A Credit Default Swap (CDS) is a financial derivative that allows investors to hedge against the risk of default by a borrower, typically a corporation or sovereign entity. It’s a contract between two parties: the buyer and the seller.

Here’s how it works:

1. Buyer: An investor buys a CDS from a seller to protect against the default of a reference entity (e.g., a corporation).
2. Seller: The seller agrees to compensate the buyer in the event of a default by the reference entity.
3. Premium: The buyer pays a regular premium to the seller, usually quarterly, for the duration of the contract.
4. Notional amount: The CDS contract specifies a notional amount, which is the amount of money that will be paid out in the event of a default.
5. Credit event: If a credit event occurs (e.g., the reference entity defaults on a loan or files for bankruptcy), the buyer can trigger the CDS and receive the notional amount from the seller.
6. Settlement: The seller pays the buyer the notional amount, and the contract is terminated.

Example:

Suppose an investor buys a CDS from a bank to protect against the default of XYZ Corporation. The notional amount is $1 million, and the premium is 2% per annum. If XYZ Corporation defaults, the investor can trigger the CDS and receive $1 million from the bank. The bank, in turn, assumes the risk of XYZ Corporation’s default.

Purpose of CDS:

CDS allows investors to:

• Hedge against credit risk
• Speculate on the creditworthiness of a reference entity
• Gain exposure to credit markets without holding the underlying bonds

However, CDS can also increase systemic risk and contribute to market instability if not used properly.