Credit Default Swaps are one of the most popular credit derivative products to be traded on stock markets today. They have gained immense popularity and prominence in the last few years especially in the financial markets of the Western World.
To understand what a credit default swap is one must first understand the reason for its existence.
Contracts on credit carry with them the inherent risk of default by the debtor/borrower. For example a bank which loans out money (lender) to a party (borrower) has to be prepared for the possible default by such borrower when the repayment of the loan is due. For years the banks and financial institutions bore the risk of such default. But credit derivatives have changed it all allowing them to trade such credit risks and hedge their potential losses.
In simple terms, a Credit Default Swap is one such product which provides insurance to any party (maybe a bank or financial institution) against the risk of default by another party (known as reference entity). This insurance has to be bought by the first party from a third party (seller of the insurance) in exchange of periodic payments by him to the insurer until the life of the Credit Default swap or till the default by the reference entity (known as the credit event) occurs. The buyer of the insurance obtains the right to sell bonds of the reference entity at their face value and the insurer agrees to buy them in the face of a credit event at their face value.
This settlement can take place in the physical delivery form or in cash. Hence the first party or lender has managed to hedge himself against the potential loss of default by the borrower or second party. The third party herein gets paid periodically for bearing the ultimate credit risk
In actual terms such arrangements are commonplace between banks, their customers and insurance companies. Despite the popularity, the product has its drawbacks, the most glaring one being what is known as ‘Asymmetric Information Problem’ which means that the party bearing the credit risk of default is different from the party which has created the credit contract having information on the creditworthiness of the borrowing party or reference entity.
An example of how extensive use of this product and market has impacted the economy as a whole is the recent sub prime crisis in the United States and its massive fallout on the banking and insurance sectors worldwide. A more prudent approach and stricter regulations would give the credit default swaps (CDS) respectability and wider reach in the future.