Credit Default Swap Trading: A Primer
Credit default swaps (CDS) hedge bond or loan default. The swap buyer pays the seller regularly to insure against a credit event, generally a default.
Credit default swaps might be confusing for trading beginners, but basic knowledge can help. Step by step.
Credit default swaps operate how?
The protection buyer and seller sign a credit default swap agreement. To protect against debt security default, the buyer pays the seller an insurance-like fee.
If the debt security fails, the seller must pay the buyer the face value less the recovery rate. This is the expected debt recovery rate in event of default.
Credit default swaps insure. The buyer pays a premium to transfer debt security credit risk to the seller. Buyers are paid and sellers pay for defaults.
Credit default swaps trade
Financial and institutional investors value credit default swaps. They allow investors to adjust debt securities and portfolio exposure to mitigate credit risk.
Hedge funds may acquire corporate bond credit default swaps to hedge against default. Even with many bonds, the hedge fund may limit default losses. Credit default swaps allow financial institutions to profit by absorbing default risk in exchange for premium payments.
Credit default switch pros and cons
Credit default swaps have several benefits. They reduce portfolio losses by hedging against default. They boost liquidity by allowing investors trade credit risk without buying or selling debt.
Credit default swaps are dangerous. In default, counterparty risk—the seller not satisfying its obligations—is a key risk. Market instability was induced by major financial institutions’ credit default swap contract defaults in 2008.
Also, credit default swaps are sophisticated and hard to price. Incomplete market transparency makes it hard to analyze these derivatives, which might cause mispricing and volatility.
Conclusion
CDSs assist investors manage credit risk. They assist investors and financial institutions control risk when used appropriately, despite their negative reputation from the 2008 financial crisis.
As with any financial instrument, beginners must understand credit default swap risks and rewards before investing. Credit default swap investors may benefit from financial advice or research.