Definition:

– A Credit Default Swap (CDS) is a bilateral contract between two parties where one party (the protection buyer) makes periodic payments to the other party (the protection seller).
– In return, the protection seller agrees to compensate the protection buyer if a specified credit event occurs, typically the default of a reference entity (such as a corporation or sovereign entity) on its debt obligations.

Parties Involved:

– Protection Buyer: The party purchasing protection in a CDS contract. They are typically looking to hedge against the risk of default on debt instruments they hold or are exposed to.
– Protection Seller: The party selling protection in a CDS contract. They receive premiums from the protection buyer and assume the risk of paying out in case of a credit event.

Reference Entity:

– The entity whose credit risk is being transferred or hedged through the CDS contract. It can be a corporation, sovereign government, or other entities with debt obligations.

Credit Events:

– Default: The most common credit event triggering a payout under a CDS occurs when the reference entity fails to meet its debt obligations, such as missing interest or principal payments.
– Restructuring: In some contracts, a restructuring of the reference entity’s debt (such as a debt exchange or modification) may also trigger a payout.
– Bankruptcy: The reference entity filing for bankruptcy or undergoing insolvency proceedings can also be considered a credit event.

Premium Payments:

– The protection buyer pays periodic premiums (similar to insurance premiums) to the protection seller throughout the life of the CDS contract.
– The amount of premiums is determined based on factors such as the creditworthiness of the reference entity, market conditions, and the perceived risk of default.

Settlement:

– If a credit event occurs (e.g., the reference entity defaults), the protection seller is obligated to pay the protection buyer the face value of the defaulted debt or the difference between the face value and the recovery value, depending on the terms of the contract.
– Settlement can be physical (delivery of the actual defaulted debt securities) or cash (payment of the difference in value).

Uses of CDS:

– Risk Management: Investors and institutions use CDS to hedge against credit risk exposure in their portfolios. For example, holders of corporate bonds may purchase CDS to protect against the risk of issuer default.
– Speculation: Traders and investors may also use CDS to speculate on changes in credit spreads or creditworthiness of reference entities without holding the underlying debt.

Market and Regulation:

– CDS contracts are typically traded over-the-counter (OTC) between institutional investors, banks, and other financial institutions.
– Regulatory oversight of the CDS market aims to enhance transparency, mitigate systemic risk, and ensure fair market practices.

Credit Default Swaps provide a mechanism for managing and transferring credit risk exposure, playing a crucial role in financial markets for pricing credit risk, managing portfolio risk, and hedging against default events.