Credit Default Swap, CDS
Credit Default Swaps, CDS is the most common type of credit derivative and powerful force on the world market. The first contract Credit Default Swap was represented by JP Morgan in 1997, and already by the middle of 2007 the volume of the market has increased rapidly to about $45 trillion. According to the data of the International Association of swaps and derivatives of this market in two times exceeded the size of the American stock market.
How does Credit Default Swap
The contract of credit default swaps provides for the transfer of credit risk municipal bonds, bonds of the developing markets, mortgage-backed securities and corporate debt from one side to the other. It is very similar to an insurance policy, because it also gives the buyer of the contract, which is often belongs to the basic credit default protection, reduction in the credit rating or other negative «credit events». The seller of the contract takes credit risk, which the buyer does not want to assume, in exchange for periodic payments for the protection, such insurance premium. In this case the seller of the contract will be obliged to pay compensation to the buyer only in the case if there is a negative credit event. It is important to note that the agreement of the credit default swaps are not actually attached to the bonds, but instead refers to it. Therefore, bond, involved in the operation, called «the obligation of reference». The contract may refer to only loan, or some of the credits, United in the pool.
As it was already mentioned above, the buyer of a Credit Default Swap will receive protection or income, depending on the objectives of the operation when the specified in the contract of entity (the Issuer) is a negative credit event. When such an event takes place, the party, which has sold credit protection (i.e. accepted credit risk) can compensate for the buyer or the current cash value of the bonds-a reference, or make physical delivery of the bonds, depending on the conditions agreed at the moment of signing the contract. If a credit event does not occur, the seller of protection receives periodic payments from the buyer, and will make a profit, if the underlying debt obligation will be executed by the borrower in full, that is on it will not be defaulted. However, the seller of the contract assumes the risk of substantial losses, if a credit event happen.
Hedging and speculation
Credit Default Swap is used to achieve the following objectives.
1. The contract of Credit Default Swap can be used as a hedge or policy of insurance as a protection against a default on the notes or the loan. A private person or a company, which is subject to a large credit risks may transfer part of it, buying protection in the form of Credit Default Swap. This may be more preferable than the direct sale of securities directly, if the investor wishes to reduce exposure to risk, but does not eliminate it entirely, to avoid the tax impact, or eliminate exposure to the risk for a certain period of time.
2. Speculators are widely used Credit Default Swap, to «bet» on the creditworthiness of a basic legal entity. The volume of the market of credit default swaps are significantly greater than market bonds and loans, which are the basic debt obligation in the contract. Thus, it becomes absolutely clear that speculative operations with credit default swaps are one of the main engines of the market. In addition, this tool provides a very efficient way to get an idea about the creditworthiness of the underlying legal entity. An investor with a positive view of the creditworthiness of the company may sell the protection and receive payments from the parties, which signed a deal with him, instead of having to spend a lot of money, putting them directly in the company's bonds. Investor with a negative perception of the company's creditworthiness can buy protection for the relatively small in size periodic payments and get a larger payment, if the company allow defaulted on their bonds, or there is any other credit event. Credit Default Swap can also serve as a way to gain access to the desired maturity, which is not available other manner; to the desired level of credit risk in the conditions of limited real-offering of the notes; or the possibilities of investing in foreign loans without exposure to foreign currency exchange rate risk.
The investor can actually copy the exposure to the risk of the bonds or bonds portfolio, using a Credit Default Swap. This can be very useful in a situation where one or more of the bonds is difficult to buy on the open market. Using the portfolio of credit default swaps, an investor can create a synthetic portfolio of bonds, which has the same credit risk and payment.
Trade Credit Default Swap
Although up to this point we considered only the retention of the Treaty of credit default swaps until the expiration of its validity term, however, they sell on a regular basis. Contract value varies depending on the increase or decrease the likelihood that the base of the legal person happens credit event. The growth of the possibility of such events will increase the value of the contract to the buyer of protection and reduce it to the seller. If the probability of a credit event is reduced, it will all be on the contrary. A trader at the market can assume that the creditworthiness of some basic legal entity decrease after some time in the future, and he buys protection on a very short time in the hope to obtain profit from this transaction. The investor can withdraw from the contract by selling their assets to the other party, terminate the credit default swap offset transaction, or to terminate the transaction with the original counterparty. As credit-default swaps are traded on the over-the-counter market (OTC), trafficking implies knowledge of the mechanisms of work, properties of the underlying assets and methods of their assessment (for this purpose usually use specialized computer programs). Considering all the above, we can conclude that they are better suited to institutional, and not private investors.
Market risks
As the market for Credit Default Swap is over the counter, and, accordingly, unregulated, the agreements are often traded so that it is difficult to find out who stands on both sides of the transaction. There is always a possibility that the buyer risk does not have sufficient financial capacity to fulfill their obligations upon the occurrence of a credit event. This makes it difficult to objective assessment of the value of the Credit Default Swap. Leverage used in many operations with credit default swaps, and the possibility that a General decline of business activity in the market could cause massive defaults and challenge the ability of buyers risk to fulfil their obligations, increases the level of uncertainty.
Let us summarize the results
Despite these problems, credit default swaps have proved their usefulness as a tool for portfolio management and for speculative operations. Because they are still one of the most important parts of the financial markets.
