Business, Legal & Accounting Glossary
A Credit Default Swap or CDS is actually a swap contract. For this, the buyer of this type of swap is provided with protection when making numerous payments to the seller, who is also protected. In exchange for making this swap, the seller is given a payoff if for some reason the bond or loan were to default. The easiest way to think of the Credit Default Swap or CDS is that this bilateral contract is set up between the buyer and seller so both parties are protected.
A credit default swap is a credit derivative. A credit default swap is also called CDS. A credit default swap is similar to an insurance contract in that it transfers credit risk associated with a transaction or investment product from the purchaser of such credit default swap to the seller of the credit default swap. Under the terms of a credit default swap contract, the seller agrees to bear the credit risk of a counterparty or an investment product in exchange for premium payments by the buyer of the credit default swap. In the event, a credit event is triggered (i.e. bankruptcy, payment default), the seller of the credit default swap will have to compensate the buyer of such credit default swap in accordance with the terms of the credit default swap contract. For example, during a cash settlement of a credit default swap, the seller will pay the buyer of the credit default swap the difference between the market value and the par value of the investment product. Credit default swaps are sold over the counter. Credit default swaps are not regulated so there are added risks that the seller will not perform if a credit event is triggered.
While credit default swap trades can be resold on the open market multiple times, there is no oversight to guarantee that in the end, the credit default swap seller will be able to pay up if a credit event is triggered. Credit default swap contracts have been under a lot of scrutinies as a result of the financial events that started with the US subprime loan crisis in 2007 and ultimately resulted in the bankruptcy, buy-out and government take over of many major financial institutions (i.e. Bear Sterns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers)
If the buyer were to purchase a bond whereby an obligation with the government or a corporation has been created, the issuer of the bond becomes known as the “reference entity”. However, the bond associated with the Credit Default Swap contract is actually not included. Instead, the buyer making quarterly premium payments, which are known as the “spread”, is protected in that the bond would be what it is sold as and the seller would be protected in case the buyer was to stop making the required payments.
With a Credit Default Swap or CDS, if the buyer were to default to the reference entity, the seller would pay the buyer the par value of that bond but in return, the buyer would give the seller the physical bond. Now, there are cases when the buyer and seller will agree to make a cash settlement or the reference entity might actually go to auction. Regardless, with a Credit Default Swap, if the buyer were to default, this would be called the “Default Event”.
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This glossary post was last updated: 28th March, 2020