A credit default swap (CDS) is a derivative referencing the credit of the 'reference entity.' A derivative is simply a contract.
You can think of a credit default swap (CDS) as kind of like auto insurance. Let’s say you are buying car insurance for yourself:
- You purchase car insurance from an insurance company
- You will make periodic payments to the insurance company
- If you do not get in an accident, the insurance company keeps the money
- If you do get in an accident, the insurance covers the cost of the damages
A CDS is similar but not identical. One difference is, with a CDS you are buying insurance to protect against a credit event of the reference entity:
- The buyer will purchase a CDS to insure against the reference entity
- The CDS buyer will make periodic payments to the seller
- If the reference entity does not suffer a credit event, as defined by the ISDA, the CDS seller keeps the payments
- In the case of a credit event, the CDS buyer receives full value, and the CDS seller typically receives the defaulted security from the CDS buyer (as an auto insurer would receive a totaled vehicle)
So the main difference between your buying car insurance and buying a CDS is who you are referencing. When you buy car insurance, you are protecting yourself against financial loss in case you are in an automobile accident or your car is otherwise damaged--you are protecting against something happening to you or your property (your car). With a CDS, you are buying insurance to protect yourself against financial loss in the event a credit event occurs to a third party, akin to life insurance.
Credit default swaps are useful to a bondholder who buys protection (the CDS) to hedge (or "insure") against a credit event. The availability of this added assurance makes for better demand for the reference security, timely when considering the risky bank, municipal and European sovereign debt markets today.
Investors can also buy and sell CDS even when they don’t own the security, typically a bond. This allows for traders to speculate on the creditworthiness of reference entities. This is called a naked credit default swap. Naked CDS constitute most of the market for credit default swaps. This is important because the risk can be partially borne by professional speculators, as opposed to the entirety of the risk being borne by the reference entity. Speculators also perform a similar function when considering derivatives in agricultural commodities, the professional speculator bears part of the risk for the farmer. In fact, when the U.S. considered banning naked CDS during the crisis, no other than “the Agriculture Committee had concerns about this proposal," reported Bloomberg.
Another great example is the chart below, where CDS rates for subordinated bonds (the reference entities in this case) are shown for a few European banks. If investors are unable to buy insurance on the bond, they may not buy at all, or they would demand a higher rate of interest (a lower price) for the bond. The higher rate of interest demanded effectively places the full risk of a credit event on the issuing bank.
Credit default swaps are priced in basis points (bps), where 5 bps = .05%.
In the above example, to insure the subordinated debt of Commerzbank, a CDS buyer would pay 6.52% annually to the seller. Therefore a typical 5 year contract covering $10 million in debt would cost $652,170 over the first year. Contrast that with an equivalent example, except now insuring IBM senior debt, at only 36.65 bps, the cost would be $36,650 in year one.
Credit default swaps are taking on a new role recently as central banks influence and fix debt markets directly. This has led to interest rates (and the other side of the same coin, debt prices) misleading both investors and debtors. As opposed to misjudging risk, parties are turning to less manipulated CDS prices for insight into credit quality and direction.