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Credit Default Swaps

Posted in Finance Articles, Total Reads: 2839 , Published on August 12, 2011

A CDS is a privately negotiated bilateral contract that serves as a kind of insurance against credit risk. The buyer of protection pays a fixed fee or premium to the seller of protection for a period of time and if certain pre-specified “credit event” occurs, the protection seller pays compensation to the protec­tion buyer, thus insulating the buy­er from a financial loss.

Credit Swaps

Credit event can be described as bankruptcy of the company or default of the bond or any other debt issued by the company. If the credit event doesn’t occur during the tenure of the swap then the protection buyer continues to pay the premium until maturity. Hence, CDS is an instrument which helps the buyer of the CDS hedge against the credit risk.

Credit risk is the risk involved in all the transactions of borrowing and lending. If you lend money what are the chances that borrower will make the repayment. In case the borrower is likely to promptly return the money then you have the low credit risk. If there is high probability of default then you have the high credit risk.

For example, suppose there is a person who lends Rs 1000 to person B on Monday. Person B promises to pay him back on Friday. But there is a possibility that person B may default in paying back person A in the event of bankruptcy.  Therefore person A gets into contract with person C to take over the credit risk of this transaction, in case person B defaults. According to contract, person A pays a onetime premium of Rs 100 to person C.

Now consider two situations. In the first situation person B pays back Rs 1000 to person A. Since person B has not defaulted, the transaction ends between persons A & B, and also between person A&C. In the second situation, person B defaults in his payment to person A. Now, according to the contract, between A & C, it becomes obligation of person C to pay back Rs 1000 to person A.

This contract which transfers the credit risk from one person to another is called credit default swaps. It is exercised when one party defaults in its payment. It consists of a Swap of a buyer and a seller.

CDS Flow

CDS resembles an insurance policy. The buyer pays the premium and the insurance company undertakes to make good your loss.

CDS impact on Indian corporate bond market.

CDS on the corporate bonds are believed to increase the depth of the market. A bank that has reached the group or individual exposure limit for a particular corporate can buy protection for a specified amount. Thereby it can lend more than the gross exposure limit by hiving off risky assets from their balance sheet. This will spur the activity in the bond market as investors will be able to hedge the credit risk component. The assumption that it will help in bringing price discovery in corporate debt market is debatable. Corporate bonds market is still illiquid and majority of the bonds traded in the market are government issued bonds. While CDS spreads can be known, it is difficult to estimate the extent of the spread attributable to liquidity and credit compo­nents of risk.

Though RBI has come up with guideline for introducing CDS on corporate bonds, it remains to be seen, how successful that approach would be. In the next article, we will analyze the RBI’s steps in introducing CDS market in India.  

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