Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Credit Default Swap (CDS)

What it is:

A credit default swap (CDS) protects lenders in the event of default on the part of the borrower by transferring the associated risk in return for periodic income payments.

How it works (Example):

In a credit default swap (CDS), two counterparties exchange the risk of default associated with a loan (e.g. a bond or other fixed-income security) for periodic income payments throughout the life of the loan. In the event that the borrowing party (the issuer) does default, the insuring counterparty agrees to pay the lender (bondholder) the par value in addition to lost interest. The bondholder (lender) seeks protection against the risk that the issuing company (borrower) might default. The insuring counterparty hedges that the issuing company will not default, and will ultimately profit from the income payments without having to compensate the bondholder for the par value and remaining interest.

To illustrate, suppose Bob holds a 10-year bond issued by company XYZ with a par value of $1,000 and a coupon interest amount of $100 each year. Fearful that XYZ will default on its bond obligations, Bob enters into a CDS with Steve and agrees to pay him income payments of $20 (similar to an insurance premium) each year commensurate with the annual interest payments on the bond. In return, Steve agrees to pay Bob the $1,000 par value of the bond in addition to any remaining interest on the bond ($100 multiplied by the number of years remaining). If XYZ fulfills its obligation on the bond through maturity after 10 years, Steve will make a profit on the annual $20 payments.

Why it Matters:

A credit default swap protects bondholders and lenders against the risk that the borrower will default. The lender's insuring counterparty takes on this risk in return for income payments. In this respect it is important for the insuring counterparty to fully assess the swap's risk/return feature to ensure it is receiving fair compensation vis-à-vis the level of risk.