Credit Default Swap (CDS)

Credit Default Swaps (CDSs) are derivative contracts between two parties, where the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a certain credit event, such as a default, occurs. The buyer of a CDS seeks to mitigate the risk of losing their investment if the issuer of the security (typically a bond or a loan) defaults, while the seller of the CDS assumes this risk in exchange for the payments. Recently, the cost of CDSs has surged due to various economic factors such as rising interest rates, an increased risk of a U.S. recession, the war in Ukraine affecting Germany's economy, pressure on U.K. pension funds from failed investments, and concerns about China's housing market​.

A CDS is like an insurance policy, where the buyer of the CDS makes payments to the seller and receives a payoff if the loan defaults​.

A Credit Default Swap (CDS), like those we create for our clients, is a financial derivative or contract that allows an investor to "swap" or offset their credit risk with that of another investor. Here's a brief overview of how a CDS is traded:

1. Establishment of the Contract: In a typical CDS contract, there are two parties: the protection buyer and the protection seller. The buyer of the CDS seeks insurance against the default of a particular debt (this could be a bond or loan, etc.). The seller of the CDS contract assumes this default risk. In return, the protection buyer makes regular payments (known as the "premium" or "spread") to the protection seller. The referenced debt is known as the "reference entity" or "underlying asset."
2. Trading on the Market: CDS contracts are not traded on a formal exchange like stocks or commodities. Instead, they are over-the-counter (OTC) derivatives that are traded between private parties, often facilitated by investment banks. The terms of each CDS contract, such as the premium, maturity, and notional amount, can be customized based on the needs of the two parties. This allows for a lot of flexibility, but it also means that there is a high degree of counterparty risk (the risk that the other party will not fulfill their obligations) associated with each trade.
3. Secondary Market: Once a CDS contract has been established, it can be traded on the secondary market. This means that a protection buyer or seller can offload their position to another investor before the contract reaches its maturity. The price of a CDS on the secondary market will fluctuate based on the perceived credit risk of the underlying asset. If the market believes that the risk of default has increased, the price of the CDS will go up, and vice versa.
4. Credit Event: If the reference entity defaults on its debt, a "credit event" is triggered. The protection seller is then required to pay the buyer the full notional amount of the contract, while the buyer must deliver the defaulted debt to the seller. If the contract is cash settled, the seller pays the buyer the difference between the notional amount and the recovery value of the defaulted debt.
5. Termination: If no credit event occurs by the maturity of the contract, the CDS terminates. The protection buyer will have paid premiums over the life of the contract, but they will not receive a payout since no default occurred.

CDSs are complex financial instruments and carry a great deal of risk. As such, they are generally only traded by sophisticated investors and financial institutions. It's essential for traders to fully understand these risks and to carefully monitor their CDS positions. Furthermore, because the CDS market is largely unregulated, it requires a high degree of transparency and trust between trading partners.