Full-Form of CDS – Credit Default Swaps
The full form of CDS is Credit Default Swaps. A credit default swap is a financial agreement that is done between the third party and the buyer. In this case, the seller ensures to compensate in case the acquired asset defaults for any reason to the buyer. CDS is also known as a credit derivative contract or instrument which is signed between two counterparties, i.e., the buyer and the third party, who agree to take the swap of the risk.
At the time of the financial crisis, the CDS works as an insurance company for the buyer of that instrument since the sellers are required to compensate for the losses in that unlikely situation. The Credit default swap helps to transfer the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. from the buyer to the third party. With its special mechanism credit, the default swap is very popular nowadays.
- CDS is a derivative instrument that helps the buyers to shift their credit risk to the third party.
- It also acts as an insurance policy to the buyer since it promises to compensate the buyer through its sellers in case of any default.
- CDS helps the buyer to eliminate the possibility of loss or risk in the financial transactions, thus provides them encouragement to invest further.
- In this, the buyer will be provided with the face value of the loan in case of default, whereas the sellers are required to possess the loan in market value. This makes a huge difference in price.
Types of CDS
There are four types of CDS.
- Credit Default Swap on single entities.
- Credit default swap on bulk entities.
- First loss Credit default swap.
- Credit default index swap.
How Do CDS Work?
The Credit default swap is a derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based. that gives the buyer the privilege to swap or transfer the credit risk to the third party. The buyer is required to pay some upfront fees to the party from whom they enter into a contract, and in return, the third party will protect the buyer in case of any default situation.
Example of CDS
A company, XYZ Limited, has issued bonds in the market. There are many buyers to those particular bonds, and then the bonds have started to be issued publically. Somewhere the buyers were tensed about what if the company defaults in giving them return, so by that thought, the buyers enter into a contract of safeguarding the interest of the buyers in case of defaults, and this is called a credit default swap.
Uses of CDS
- It helps build confidence among the buyers that their interest is safeguarded and that they can invest in the market freely.
- CDS helps to manage the risk of the buyer.
- The companies can be relieved from the diversification if they opt for a Credit default swap.
- It helps the buyers to easily remove the liability or default amount of the loan from the balance sheet.
- CDS helps in easy transfer of the risk to the third party or the seller.
Risks of CDS
- It has been seen that the contracts of credit default swap between the parties are not legal sometimes.
- The government may not take any action against the seller in case the default occurs.
- If the buyers involve third parties like bank or insurance companies to pay off their debts, then it may so happen that the third party may also fail to help the buyer to compensate the amount from the sellers.
Credit Default Swaps vs. Interest Rate Swaps
- It is riskier than the interest rate swaps.
- In Interest Rate SwapsInterest Rate SwapsAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate., the swap is done for the interest provision of any instrument, whereas in the Credit default swap, the swap is done for the loan amount of the instrument.
- In this swap, the buyers are given an assurance of compensation from the sellers, whereas, in the Interest Rate Swaps, this provision is not there.
- It is that it has a risk protecting provision to the buyers.
- The risk is transferred to the seller in case of default.
- The buyers will get the compensation from the seller as per the credit default swap agreements.
- The buyer will get encouragement to invest in risky investments, and thus the financial instrument can be more beneficial to the investors.
- In case of default, the buyer is free to remove the liability from their balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
- By using these swaps, companies can help themselves from diversification.
- The buyers get the protection by paying a very amount as compared to the loan amount as premium money to the seller or the third party to whom they have entered into the contract.
- In case of default, the buyer will be compensated for the loan amount from the seller in the current market price and not the face value of the loan amount.
- The credit default swap can be misleading if they are not authorized, they may make premium money from the buyers, and ultimately the default occurs.
- They can be very discouraging for those who are opting to invest more money in the contracts.
- The third-party may, however, fail to make the compensation possible to the buyers in case the sellers default the payments.
- The risk associated can be very high in case the proper investigation is not done before entering the contract.
A credit default swap is a very new concept and a very complicated mechanism. It can be enjoyed with the buyers only if it is genuine. The investors should take extra care before investing their money or before entering such contracts.
This has been a guide to the Full Form of CDS, i.e. (Credit Default Swaps) and its definition. Here we discuss how does CDS works with an example, types, and uses. You may refer to the following articles to learn more about finance –