Credit Default Swap

Posted in Finance, Accounting and Economics Terms, Total Reads: 1923

Definition: Credit Default Swap

Credit Default Swap is a swap agreement between a CDS seller & a CDS buyer. The CDS buyer (like an investor) under the mentioned contract makes regular premium payments to the seller. The CDS seller (like Banks or other financial institutions) in exchange pays for the loss in case the underlying loan/bond defaults.

There are 3 parties in the process:

  • CDS Buyer
  • CDS Seller
  • Bond issuer

There can be 2 scenarios

Scenario 1: No Default on the underlying bond

In this case, the CDS buyer makes regular payments to the seller according to the contract terms. There is no default and hence the bond issuer pays interest payments also regularly. 

Scenario 2: Default of the underlying bond

When the bond issuer defaults (ie., unable to pay the interest or repay back the principal on maturity), the CDS seller pays the CDS buyer (who has insured himself on this bond) an amount which is equal to the par value of the bond. In exchange the CDS seller receives the ownership of the bond from the bond holder.

Thus a CDS agreement helps the buyer to swap the credit risk in case the issuer of bond defaults.

It is always not necessary that the CDS buyer should be holding the credit instrument (bond/loan). Such a case is called as Naked Credit Default Swap. There have been many critics against this concept of Naked CDS saying that a person who does not hold a bond should not be able to buy CDS.

Hence, this concludes the definition of Credit Default Swap along with its overview.

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