Credit default swaps - what they are and pros and cons

When in the world of finance, you might have come across the term 'credit default swap', CDS for short. This idea, first introduced by JP Morgan, has become notorious in recent years. Keep reading for our guide to what credit default swaps are, their benefits and disadvantages, and how to buy one yourself.

Definition of credit default swaps

Credit default swaps refer to contracts allowing investors to swap credit risks. This is also known as hedging. If a lender is concerned about a borrower, they could decide to use a credit default swap to offset the risk. If they do, the lender will buy a credit default swap from another investor. If the borrower defaults, the investor will reimburse the lender, thereby protecting them from risk. There is parallels to insurance policies, however, credit default swaps are typically used for protection against the default of high-risk sovereign debt, corporate debt, emerging market bonds, municipal bonds, junk bonds, collateralized debt obligations, and mortgage-backed securities. The buyer of the credit default swap makes quarterly payments to the seller for providing the swap (like an insurance premium).

Advantages and disadvantages of credit default swaps

The key advantage of credit default swaps is that they protect lenders against credit risk. This means buyers are able to fund riskier ventures and ultimately lead to more innovative businesses. Companies selling credit default swaps also build a system of protection for themselves by diversifying. If, inevitably, one credit defaults, there will be fees from successful swaps to balance it out.The principle of credit default swap accounting also requires a minimal outlay of cash and can provide access to credit risk without the associated interest rate risk.

The biggest disadvantage of credit default swaps used to be its lack of regulation. Until 2009, they were unregulated, which caused their substantial role in the 2008 financial crisis. A large number of companies selling swaps were undercapitalized and lacked the funds to cover defaults. This meant that, when the debtors defaulted on their loans, could not make a payment which lead to the CDS market collapsing.

Buying a credit default swap

While credit default swaps may have a difficult history, they can still provide a useful tool. They enable you to manage portfolios and speculation better, particularly given that the market for CDS contracts is now regulated. Of course, there still is a risk involved when entering a CDS contract. Any economic downturn could massively impact the system. However, there still is a large interest in credit default swaps. If you are considering entering the credit default swap market, you can enter over the counter trades. CDS is valued with industry computer programs. Credit events determine the value of credit default swaps. If a credit event changes the value of a CDS, investors can exit the contract by selling their interest to another individual or entity.