Swap means “to exchange” and in the finance domain, swaps are contracts where two parties exchange cash flows based on two financial instruments. One such example of a swap is a Credit Default Swap or CDS.
By definition, “a credit default swap is a contract between two parties in which one party purchases protection from another party against losses from a default of a borrower.” Suppose you have invested 10 crore rupees in a corporate bond for 10 years. After 3 years, you expect the company to go into bankruptcy and fear losing your investment. Just like buying insurance for your house, you can buy insurance for your investment in bonds by purchasing a CDS. The characteristics are the same, you will have to pay a premium to the protection seller for protection against any credit risks. If the bankruptcy does happen, the company can only pay you 30 per cent of your investment, the rest 70 per cent will be paid by the protection seller. The premium paid will be decided on the notional amount which in this case is 10 crore.
Three credit events will trigger the company to not make promised payments to its investors. First is Bankruptcy, where the company goes out of business and files for bankruptcy. The second credit event is “Failure to Pay” where the company was not able to make payments due to major losses in that year without going bankrupt. The last credit event is Restructuring where the company is trying to build back up its capital by limiting financial pressure.
To buy a CDS, an investor doesn’t need to have an investment in a bond. If you expect a downturn in the economy and an increase in credit risk levels you can buy a CDS and receive the money if your expectations turn into reality. A CDS can be used to benefit if an investor feels some companies will go bankrupt and some companies that will flourish. This speculative bet was one of the major reasons for the Financial Crisis of 2008. After the crisis, many countries including India have limited the use of CDS as means to protect against default risk.
Concept: Shivangi Bhatia
Editor: Minakshi Todi