Like an insurance policy, a credit default swap can protect against the uncertainties of life — with minimal upfront payment.
Imagine you’re a small business owner with big expansion plans, but you’re short on cash and need a loan to fill the gap.
So you go to your local bank and get a loan for £10,000.
What you don’t know is that while the bank is willing to lend you the money to make your expansion dreams come true, they have slight reservations about your ability to make your loan repayments.
However, an experienced investor comes into play who not only believes in your business, but also in your ability to repay your loan.
The investor offers to pay the bank £10,000 if you default on your loan. In return for the investor taking on the risk, the bank pays the investor a small fee each month or quarter — similar to an insurance premium.
The purchase agreement between the bank and the investor is called a credit default swap (CDS).
In this article, we will discuss what a CDS is, how it works, when to use a CDS, and the pros and cons of purchasing a CDS.
What is a Credit Default Swap?
A CDS is a contract known as a financial derivative that allows a lender (the protection buyer) to exchange or exchange its credit risk with an investor (the protection seller).
To offset the risk of default, the lender (in our example, the bank) purchases a CDS from an investor who agrees to refund the face value of the loan — plus interest payments — if the borrower defaults on the loan.
However, if the borrower does not default, the investor can keep all regular “insurance payments.”
Most swaps are designed to protect the lender from a borrower defaulting on high-risk municipal bonds. They also protect against:
- Secured Debentures
- Corporate debt
- Bonds from emerging markets
- Junk bonds
- Mortgage-Backed Securities
- National debt.
How does a credit default swap work?
The investor is only obligated to compensate the lender if a default or credit event occurs.
A credit event is a set of circumstances agreed in the CDS contract that activates the swap.
The most common credit events are:
- The borrower does not repay his debts as scheduled.
- The borrower’s debt repayment terms have been changed in a way that disadvantages the lender, for example by reducing the interest rate.
- The borrower files for bankruptcy.
When is a credit default swap used?
In order of popularity, here are the three main uses of a CDS:
1. Speculation
As a swap is traded, its market value rises and falls, which can benefit a CDS trader. Investors trade swaps in the hope of profiting from price differences.
Let’s say an investor is speculating that a company’s credit rating will soon decline.
Based on this belief, the investor buys a CDS on the company’s debt and pays regular premiums to the security provider.
If the company’s creditworthiness deteriorates and a credit event occurs, the investor benefits from his speculation by paying out the security provider.
On the other hand, if no credit event occurs, the investor loses all premiums.
2. Hedging
Insurance companies, pension funds, and other security holders may purchase a CDS to protect themselves against the risk of a borrower defaulting.
Imagine a bank with a diverse portfolio of a company’s bonds.
To protect itself from the risk of default by the issuing company, the bank purchases a CDS on the company’s debt.
If the company defaults, the bank receives a payout from the security provider that offsets the losses from the defaulted bonds.
3. Arbitrage
Arbitrage is the strategy of exploiting price inefficiencies between two markets by purchasing a security in one market and reselling it in another.
Imagine an experienced arbitrage trader discovers that there is a price mismatch between the CDS market and the bond market for a particular company.
The trader then buys the company’s bonds at a lower price while simultaneously selling a CDS on the company’s debt at a higher price.
If the company defaults, the dealer makes up for the loss on the bonds by paying out the CDS.
However, if the company does not default, the dealer earns the premium by selling the CDS while retaining the bonds.
Advantages and disadvantages of a credit default swap
In addition to minimal cash outlay and access to credit risk without the associated interest rate risk, a CDS offers several other benefits:
- Risk reduction: A CDS does not eliminate risk for lenders, but it does help reduce it. This security can increase business innovation and promote economic growth.
- Diversification: A swap allows investors to diversify their portfolios, which reduces their risk because, for example, a company default can be offset by regular payments from other successful swaps.
- liquidity: The CDS market is highly liquid and offers investors the freedom to quickly enter and exit market positions while paying minimal transaction fees.
A CDS also has its disadvantages:
- Protecting Seller Risk: In the event of financial headwinds, the protection seller is unable to meet its contractual obligations under the CDS, leaving the protection buyer uncompensated in the event of a credit event. (By the way, this played a role in the Financial crisis 2007/08 and the European sovereign debt crisis of 2010.)
- False sense of security: A swap can create a false sense of security among both lenders and investors, which can lead to unhealthy risk-taking and thus the taking out of riskier loans.
- complexity: CDS contracts can be very complex and complicated documents, sometimes making it difficult for inexperienced investors to understand them (let alone assess the risks involved).
Final thoughts
A CDS is a risk management tool that transfers the risk of a borrower’s default to a third-party investor in exchange for regular payments.
This can provide a valuable safety net for your business and potentially stabilize its financial health and prospects.
However, it is important to understand the complexities of purchasing a CDS and weigh its pros and cons to ensure it is consistent with your overall risk management strategy.
After all, an exchange also has its own risks. Although it protects a lender from a borrower’s default, it also exposes that same lender to the risk that the seller of the CDS defaults.
In a sound financial climate, a CDS is a strategic tool to minimize default risk. However, in difficult financial times, purchasing a CDS can be viewed as exchanging the risk of default for another.
