Credit Default Swap (CDS) is a derivative contract that transfers *credit risk in return for a series of payments. CDS allow companies to trade and manage credit risks in almost the same way as market risks. The most popular credit derivative is a credit default swap (CDS).
In CDS, the buyer of the insurance makes periodic payments to the seller and in return obtains the right to sell a bond issued by the company for its face value if a credit event occurs. In simple words, CDS is a kind of insurance against credit risk. It is a financial contract between two parties in which the buyer of protection pays fees or premium to the seller of protection for a period of time and if a certain pre-specified “credit event” occurs, the seller of protection will pay compensation to the buyer of protection.
For Example, Rohit holds bond issued by company TechnixMedia with a par value of Rs.10,000 and a coupon interest amount of Rs.1000 each year. To keep himself on the safe side, Rohit enters into a CDS with a commercial bank and agrees to pay an income payments of Rs.200 (similar to an insurance premium) each year commensurate with the annual interest payments on the bond. In return, bank agrees to pay Rohit Rs.10,000 par value of the bond in addition to any remaining interest on the bond (Rs.1000 multiplied by the number of years remaining) if TechnixMedia defaults. Otherwise, if TechnixMedia fulfills its obligation on the bond through maturity after specified number of years, bank will make a profit on the annual Rs.200.
A “credit event” can be a bankruptcy of a company or a default of a bond or other debt issued by the company. If no credit event occurs during the term of the swap, the buyer of protection continues to pay the default swap premium (**CDS Spread) until maturity. But if credit event occurs at some point before the contract’s maturity, the seller of protection owes a payment to the buyer of protection, thus insulating the buyer from a financial loss.
One of the advantages to using a CDS is that it allows parties to efficiently manage their credit risk in a better, more efficient way. On the downside, CDS allows for huge speculation, especially in the case of ***Naked CDS.
The Reserve Bank of India had previously proposed the introduction of CDSs to the Indian market but delayed its plans due to the economic crisis in 2008. In February, the RBI placed its Draft Guidelines on Introduction of CDS on its website.
*Credit Risk – The risk that a bond issuer will default, by failing to repay principal and interest amount.
**CDS spread – Premium paid by protection buyer to the seller
***Naked CDS – When the buyer of Protection does not own the Reference Asset.