How do Credit Default Swaps Work?
Credit derivatives were created in order to transfer the credit risk inherent in an instrument from one party to another without actually transferring the ownership of these assets. Prior to credit derivatives, there was no mechanism to isolate the credit risk of any financial instrument.
Credit default swaps were amongst the first structured finance derivative products which were created to help mitigate credit risks. Over the years, the market for credit default swaps has exploded and now the total outstanding value of derivative contracts is more than $10 trillion!
In this article, we will have a closer look at what a credit default swap is and how it helps in managing the credit risk in any portfolio.
What are Credit Default Swaps?
The simplest way to describe a credit default swap is by comparing it to an insurance contract. An insurance contract typically has an insurer i.e. a person who provides protection as well as an insured i.e. a person who seeks protection. This is also the case with credit default swaps.
There are two parties involved wherein one seeks protection and the other provides it. However, they are not referred to as the insurer and the insured. Here, the protection is being sought against different types of credit events viz. bankruptcy, downgrade, and defaults.
As a part of this contract, the person buying the protection owns the underlying asset. However, they pay a premium to the seller of the protection. This premium is paid in lieu of the contractual obligation that the seller will make good their loss if any credit event takes place. The seller of the credit default swap normally does not hold any position in the underlying economy.
Types of Credit Default Swaps
Over the years, many versions of credit default swaps have been introduced into the financial market. The details of some of these versions are as follows:
Credit default swaps can also be segregated based on their maturity. CDSs can have a duration from one year to a decade. However, the contracts sold with 5 years duration are the ones that are most commonly traded on the exchange.
Benefits of Credit Default Swaps
Credit-default swaps have grown in popularity because there are certain benefits of using them. Some of them have been listed below:
How Credit Default Swaps are Settled?
Most credit default swaps are settled in one of the two ways mentioned below:
The bottom line is that over the years, credit default swaps have become one of the most widely used financial derivatives. However, that has also caused many problems. Initially, the products were created to manage risks. However, over time they started being used for speculative purposes and ended up magnifying the risk in the system.
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