Credit Default Swap

CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond. The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted. The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap. Process: A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative “credit event.” The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the “reference obligation.” A contract can reference a single credit, or multiple credits.
CDS have the following two uses:
(a) Hedging:
 A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. This may be preferable to selling the security outright if the investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate exposure for a certain period of time.
(b) Speculation:
The second use is for speculators to “place their bets” about the credit quality of a particular reference entity. With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company’s bonds. An investor with a negative view of the company’s credit can buy protection for a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has some other credit event. A CDS can also serve as a way to access maturity exposures that would otherwise be unavailable, access credit risk when the supply of bonds is limited, or invest in foreign credits without currency risk.