Credit default swap definition

What is a credit default swap?

A credit default swap (CDS) is a financial agreement that enables a lender to ‘swap’ their exposure to risk to another party. For a premium, the CDS seller takes on the credit risk of the lender, and they will compensate the lender if a borrower defaults on their loan.

How do credit default swaps work?

Credit default swaps work by enabling a lender to effectively buy insurance on an underlying loan. The buyer of the CDS will pay a premium – often quarterly – to the seller. This will shift some of the buyer’s risk if the borrower defaults on the loan to the seller of the CDS. If the borrower does default, then the credit default seller will need to make a contingency pay-out to the lender.

Hedging with a CDS

One of the main uses of credit default swaps is as a hedge against credit risk. Often, banks will buy a CDS on any loans that they issue to protect themselves against default. For example, if the borrower fails to meet their obligations, then the bank will be covered from loss through the proceeds of the contingency pay-out from the credit default seller.

Speculating with a CDS

Credit default swaps have also been used to speculate on default in the financial markets. Perhaps the most famous example is the 2008 financial crash, when the instrument was used bet against the US housing market on the assumption that people would default on their subprime mortgage loans.

Global banks and Wall Street firms sold their risk from these loans to insurance firms. In doing so they created a CDS market that would enable the firms themselves and other speculators to take a position on the loans. When the market eventually crashed, the insurance firms had to repay those who had bought the instruments.

Pros and cons of a CDS

Pros of credit default swaps

Credit default swaps can act as insurance against a damaging market event which causes borrowers to default on their debt obligations. As a result, lenders who buy a CDS are more protected against default than if they did not buy the CDS.

Cons of credit default swaps

Credit default swaps require the buyer to pay a quarterly premium to insure themselves. Because of this, the lender should assess whether their exposure to risk is sufficient to justify buying the CDS in the first place.

In a particularly damaging unexpected market event – such as the 2008 financial crisis – credit default swap sellers could also be forced to default on their obligation to pay the buyer of the CDS. If this happens, the buyer of the CDS has no protection, and they will also often lose the premium for purchasing the CDS.