Credit Default Swap

Credit Default Swaps (CDS) are fast becoming the dominant vehicle for trading credit risk.Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset's market value following the credit event.

In other words it is a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments.If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.


CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money .However, there are a number of differences between CDS and insurance, for example:The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.In contrast, to purchase insurance, the insured is generally expected to have an insurable interest such as owning a debt.Moreover, unlike insurance, CDS are unregulated