Credit Default Swap is a financial derivative providing insurance in case of a credit event, usually a default on a loan. It provides investors with protection and decreases the risk. If a creditor assumes his borrower will not meet his loan obligation, he can buy a CDS and transfer the risk to the third party. The third party agrees to pay the creditor the full amount of a loan in case of a borrower’s default and charges the premium for it. Thus, a buyer of the swap pays a premium to the seller of the swap until the maturity date of the contract. Credit risk is not eliminated but transferred to the seller of the swap. As the seller guarantees the creditworthiness of the debt the overall credit rating of the lender improves.
The CDS are not traded through an exchange and represent the over the counter (OTC) instrument. This means the contract is not standardized but customized between parties and traded directly. Thus, the market size is not well known. Moreover, there can be numerous parties involved making the CDS ownership convoluted. Many economists believe CDS are potentially dangerous because it combines priority in bankruptcy with a lack of transparency and could be unsecured. In the US Dodd-Frank Act was introduced in order to regulate the market and decrease systematic risk. The Volcker Rule prohibits the banks to use client’s deposits and invest in derivatives including swaps. The EU regulated it through MiFID II.
Even if credit event never materializes, the value of a CDS changes over time as the credit quality of the reference entity changes. As the probability of default rises the value of the contract rises as well. The value of a CDS refers to the face value of the underlying debt security. The premium that is paid by the buyer of the CDS to the seller is expressed as a proportion of the notional value of the contract in basis points.
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