How do credit default swaps (CDS) work as a type of credit derivative?

Credit default swaps (CDS) are a type of credit derivative that allows investors to hedge against or speculate on the creditworthiness of an underlying entity, such as a corporation, government, or financial institution. CDS contracts serve as a form of insurance against the risk of credit default. Here's how they work:

1. Parties Involved:

• Protection Buyer: The protection buyer is the party seeking insurance or protection against the credit risk of an underlying entity. This party makes periodic premium payments to the protection seller.
• Protection Seller: The protection seller is the party providing insurance or protection against the credit risk of the underlying entity. The protection seller receives premium payments from the protection buyer.

2. Contract Terms:

• Reference Entity: The reference entity is the entity whose credit risk the CDS contract is based on. It can be a specific corporation, government, or other entity.
• Reference Obligation: The reference obligation is the debt instrument (e.g., a bond or loan) issued by the reference entity. The CDS contract specifies the reference obligation that the protection buyer is concerned about.
• Notional Amount: The notional amount represents the face value of the reference obligation. It is the amount on which the CDS premium payments and potential payouts are calculated. The notional amount does not change hands; it serves as a reference point for calculating payments.

3. Premium Payments:

• The protection buyer makes periodic premium payments to the protection seller, similar to an insurance premium. These payments are made over the life of the CDS contract, typically at regular intervals.

4. Protection and Payouts:

• If a credit event occurs with the reference entity, such as a default on the reference obligation, the protection seller is obligated to make a payout to the protection buyer. The payout amount is determined based on the terms of the CDS contract and may be equal to the notional amount minus the recovery value of the reference obligation.
• Credit events can include default, bankruptcy, failure to make payments, restructuring, or a downgrade in the credit rating of the reference entity.

5. Settlement Methods:

• CDS contracts can be physically settled or cash settled:
  • Physical Settlement: In a physical settlement, the protection buyer delivers the reference obligation to the protection seller in exchange for the notional amount or the agreed-upon payout.
  • Cash Settlement: In a cash settlement, the payout is made in cash, usually based on the difference between the notional amount and the recovery value of the reference obligation.

6. Trading and Market Liquidity:

• CDS contracts are traded in both over-the-counter (OTC) and exchange-traded markets. The OTC market is more common and allows for customization of contract terms.
• Market participants can trade CDS contracts to take positions on the creditworthiness of various entities or to hedge existing credit exposures.

7. Credit Risk and Counterparty Risk:

• CDS contracts themselves carry credit risk, primarily counterparty risk. If the protection seller defaults, the protection buyer may not receive the promised payout. To mitigate this risk, some CDS contracts involve collateralization or use central clearing counterparties (CCPs) to reduce counterparty risk.

8. Use Cases:

• Hedging: Investors and financial institutions use CDS contracts to hedge their credit exposure to specific entities or portfolios of debt instruments.
• Speculation: Traders and investors can use CDS contracts to speculate on changes in credit risk or to profit from credit events.
• Credit Analysis: CDS prices and spreads are often used as indicators of market sentiment and credit risk assessments for specific entities.

CDS contracts are powerful tools for managing credit risk, but they also carry risks and complexities. Their use has been a subject of scrutiny and regulation in the aftermath of financial crises. Understanding the terms and risks associated with CDS contracts is essential for market participants.