Credit Default Swaps (CDS)

CREDIT DERIVATIVES are over-the-counter contracts that allow credit risk to be exchanged across counterparties.

A CREDIT DEFAULT SWAP (CDS) is a swap contract in which the buyer of the CDS pays premium (periodic or lump-sum) to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). This event of a default is called a “Credit event”. The payment made by the seller to the buyer is called a “Contingent payment” and is triggered by a credit event (CE) on the underlying credit.

These contracts represent the purest form of credit derivatives (hence called Plain Vanilla), as they are not affected by fluctuations in market values as long as the credit event does not occur. Plain Vanilla CDS cater to the largest market share of the Credit Derivatives typically with 5 year maturities.

Credit default swaps are often used to manage the credit risk (i.e. the risk of default) which arises from holding debt. Typically, the holder of, for example, a corporate bond may hedge their exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond

Example
The protection buyer, call it Mr. X, enters a 1-year credit default swap on a notional of $100 million worth of 5-year bonds issued by ABC. The swap entails an annual payment of 50bp.
At the beginning of the year, Mr. X pays $500,000 to the protection seller (the premium). At the end of the year, Company ABC defaults on this bond, which now trades at 40 cents on the dollar. The counterparty (CDS seller) then has to pay $60 million to Mr X since Mr. X can sell the bond for $40 million now
If Mr. X holds this bond in its portfolio, the credit default swap provides protection against credit loss due to default.

CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility.

CDS can be used for speculation on changes in CDS spreads. An investor who believes that an entity's CDS spreads are either too high or too low relative to the entity's bond yields may attempt to profit from that view by entering into a trade, known as a basis trade, that combines a CDS with a cash bond and an interest rate swap.

An investor may also speculate on an entity's credit quality; CDS spreads will increase as credit-worthiness declines, the investor may therefore buy CDS protection on a company in order to speculate that the company is expected to default. Alternatively, the investor might sell protection if they think that the company's creditworthiness is expected to improve.