What is a credit default swap and why is it used?

Like an insurance policy, a credit default swap can guard against life’s uncertainties—with minimal upfront cash needed.

Imagine that you’re a small business owner with big plans to expand, but you’re a little short on funds and in need of a loan to bridge the gap.

So, you stroll down to your local bank and manage to secure a £10,000 loan.

What you don’t know is that while the bank is willing to lend you the money to make your expansion dreams come true, it has slight reservations about your ability to make your loan repayments.

However, a seasoned investor enters the frame who not only believes in your business but also in your ability to repay your loan.

The investor offers to pay the bank £10,000 if you default on your loan. In return for the investor taking on the risk, the bank will pay the investor a small fee each month or quarter— similar to an insurance premium.

The purchase agreement between the bank and the investor is known as a credit default swap (CDS).

In this article, we’ll cover what a CDS is, how it works, when a CDS is used, and the pros and cons of buying one.

What is a credit default swap?

A CDS is a contract, known as a financial derivative, which enables a lender (the protection buyer) to exchange or swap their credit risk with an investor (the protection seller).

To offset the risk of default, the lender (the bank in our example) buys a CDS from an investor who agrees to reimburse it for the face value of the loan—plus interest payments—if the borrower defaults on the loan.

But, if the borrower doesn’t default, the investor gets to keep all the periodic “insurance” payments.

Most swaps are intended to protect the lender from the borrower defaulting on high-risk municipal bonds. They also protect against:

• Collateralised debt obligations
• Corporate debt
• Emerging market bonds
• Junk bonds
• Mortgage-backed securities
• Sovereign debt.

How does a credit default swap work?

The investor is only required to compensate the lender if a default or credit event occurs.

A credit event is a set of circumstances agreed upon in the CDS contract that activates the swap.

The most common credit events are when:

• The borrower fails to make a scheduled debt payment.
• The borrower’s debt repayment terms have been changed in a way that disadvantages the lender, such as reducing the interest rate.
• The borrower declares bankruptcy.

When is a credit default swap used?

In order of popularity, here are the 3 main ways a CDS is used:

1. Speculation

When a swap is traded, its market value goes up and and down, which a CDS trader can profit from. Investors trade swaps in the hope of profiting from price differentials.

Let’s say an investor speculates that a company’s creditworthiness will shortly be on the decline.

Based on this belief, the investor buys a CDS on the company’s debt, paying periodic premiums to the protection seller.

If the company’s creditworthiness deteriorates and a credit event occurs, the investor will profit from their speculation through a payout from the protection seller.

But, on the other hand, if no credit event occurs, the investor loses all their premiums.

2. Hedging

Insurance companies, pension funds and other securities holders can buy a CDS to hedge against the risk of a borrower defaulting.

Imagine a bank with a diverse portfolio of bonds issued by a company.

To guard against the risk of the issuing company defaulting, the bank buys a CDS on the company’s debt.

If the company defaults, the bank receives a payout from the protection seller, offsetting the losses from the defaulted bonds.

3. Arbitrage

Arbitrage is the strategy of capitalising on the pricing inefficiency between two markets by buying a security in one market and re-selling it in another.

Imagine a savvy arbitrage trader realises that there’s a price discrepancy between the CDS market and the bond market for a certain company.

The trader then buys the company’s bonds at a lower price and, at the same time, sells a CDS on the company’s debt at a higher price.

If the company defaults, the trader offsets the loss on the bonds by the payout from the CDS.

But if the company doesn’t default, the trader earns the premium from selling the CDS while holding onto the bonds.

Advantages and disadvantages of a credit default swap

In addition to minimal cash expenditure and access to credit risk without the related interest rate risk, a CDS offers several other benefits:

• Risk reduction: a CDS doesn’t eliminate risk for lenders, but it does go some way towards reducing it. This security can increase business innovation and promote economic growth.
• Diversification: a swap allows investors to diversify their portfolios, which reduces their risk because a default by one company, for instance, can be offset by periodic payments from other successful swaps.
• Liquidity: the CDS market is a highly liquid one, which affords investors the freedom to manoeuvre in and out of market positions at pace while incurring minimal transaction fees.

A CDS also has its drawbacks:

• Protection seller risk: during financial headwinds, the protection seller may default on their contractual obligation under the CDS, leaving the protection buyer without compensation if a credit event happens. (Incidentally, this played a part in the financial crisis of 2007/8 and the European Sovereign Debt Crisis of 2010.)
• False sense of security: a swap can create a false sense of security among lenders and investors alike, which can result in an unhealthy risk appetite and riskier loans being taken out as a result.
• Complexity: CDS contracts can be highly complex and intricate documents, which sometimes make them difficult for novice investors to understand (let alone appreciate the risks involved).

Final thoughts

A CDS is a risk management tool which transfers the risk of a borrower’s default to a third-party investor in return for periodic payments.

Doing so can provide a valuable safety net for your business, potentially stabilising its financial health and outlook.

But, it’s important to understand the complexities involved in buying a CDS and weigh up its pros and cons to ensure that it aligns with your overall risk management strategy.

After all, a swap has risks of its own. Even though it protects a lender from a borrower’s default, it also exposes the same lender to the risk that the seller of the CDS may default.

In a solid financial climate, a CDS is a strategic tool used to minimise the risk of default, but in challenging financial times, buying a CDS can be seen as exchanging the risk of one default for another.