A credit default swap (CDS) is a financial instrument or contract that allows an investor to “swap” or hedge another investor’s credit risk.
For example, if a lender is worried that a borrower will default on a loan, then the lender may use a CDS to mitigate or swap the risk.
To swap the default risk, the lender purchases a CDS from another creditor. Then, he/she offers to repay the lender in the case of default on the borrower. In order to continue the contract, which is like an insurance policy, most CDS would require a continuous premium payment.
The Definition of Credit Default Swap
The purpose of a credit default swap is to transfer credit exposure between two or more parties of fixed income products. In a CDS the swap buyer makes payments to the seller of the swap until the contract’s maturity date.
Credit default swaps are the most common type of OTC credit derivatives. In addition, the function is usually to transfer credit exposure to fixed-income products for risk hedging purposes.
One type of credit derivative contract is a credit default swap.
They have become a highly popular way of managing this type of risk. The U.S. Currency Comptroller issues a quarterly report on credit derivatives. And then, put the size of the entire market at $4.2 trillion. CDS then accounted for $3.68 trillion, in a report released in June 2018.
Bonds and other debt instruments are at risk of the borrower not repaying the loan or interest on it. Since debt securities also have long maturity periods of up to 30 years, it is difficult for the borrower to make accurate assessments of the risk over the instrument’s entire lifetime.
The Example of a Credit Default Swap
During the European sovereign-debt crisis, credit default swaps were widely used. Greece’s government bonds had a 94 percent chance of default in September 2011.
Investors holding Greek bonds should have paid upfront $5.7 million and $100,000 per year for a five-year credit default swap (CDS) to guarantee $10 million worth of bonds.
Many hedge funds have even used CDS as a way to speculate on the likelihood of the country defaulting.