If you have seen 'The Big Short' then you may already know a thing or two about credit default swaps (as explained by Margot Robbie in a bubble bath). For those of you who don't know about them, odds are you have heard them mentioned in the news as a main source of angst for the entire US economy. Credit default swaps (or CDS's) were one of the primary causes of the market crash and subsequent depression in 2008-2009, and although you'd think they would be illegal now, they most definitely are not. Learn a bit more about them below, with the help of details from Investopedia.
What are 'Credit Default Swaps'?
A credit default swap is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. In a credit default swap, the buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract. In return, the seller agrees that, in the event that the debt issuer defaults or experiences another credit event, the seller will pay the buyer the security’s premium as well as all interest payments that would have been paid between that time and the security’s maturity date.
A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.
A credit default swap is also often referred to as a credit derivative contract.
In what context are CDS' used?
Any situation involving a credit default swap will have a minimum of three parties. The first party involved is the financial institution that issued the debt security in the first place. These may be bonds or other kinds of securities and are essentially a small loan that the debt issuer takes out from the security buyer. If an institution sells a bond with a $100 premium and a 10-year maturity to a buyer, the institution is agreeing to pay back the $100 to the buyer at the end of the 10-year period as well as regular interest payments over the course of the intervening period. Yet, because the debt issuer cannot guarantee that they will be able repay the premium, the debt buyer has taken on risk.
The debt buyer in question is the second party in this exchange and will also be the CDS buyer should they agree to enter into a CDS contract. The third party, the CDS seller, is most often an institutional investing organization involved in credit speculation and will guarantee the underlying debt between the issuer of the security and the buyer. If the CDS seller believes that the risk on securities that a particular issuer has sold is lower than many people believe, they will attempt to sell credit default swaps to people who hold those securities in an effort to make a profit. In this sense, CDS sellers profit from the security-holder’s fears that the issuer will default.
CDS trading is very complex and risk-oriented and, combined with the fact that credit default swaps are traded over-the-counter (meaning they are unregulated), the CDS market is prone to a high degree of speculation. Speculators who think that the issuer of a debt security is likely to default will often choose to purchase those securities and a CDS contract as well. This way, they ensure that they will receive their premium and interest even though they believe the issuing institution will default. On the other hand, speculators who think that the issuer is unlikely to default may offer to sell a CDS contract to a holder of the security in question and be confident that, even though they are taking on risk, their investment is safe.
Though credit default swaps may often cover the remainder of a debt security’s time to maturity from when the CDS was purchased, they do not necessarily need to cover the entirety of that duration. For example, if, two years into a 10-year security, the security’s owner thinks that the issuer is headed into dangerous waters in terms of its credit, the security owner may choose to buy a credit default swap with a five-year term that would then protect their investment until the seventh year. In fact, CDS contracts can be bought or sold at any point during their lifetime before their expiration date and there is an entire market devoted to the trading of CDS contracts. Because these securities often have long lifetimes, there will often be fluctuations in the security issuer’s credit over time, prompting speculators to think that the issuer is entering a period of high or low risk.
It is even possible for investors to effectively switch sides on a credit default swap to which they are already a party. For example, if a speculator that initially issued a CDS contract to a security-holder believes that the security-issuing institution in question is likely to default, the speculator can sell the contract to another speculator on the CDS market, buy securities issued by the institution in question and a CDS contract as well in order to protect that investment.
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