Investors can use various hedging techniques to mitigate the risks associated with their equity and debt instruments. These techniques include the use of options, swaps, forwards, futures, etc. Usually, these use derivates, which are financial securities that get their value from an underlying asset or group of assets. One method of hedging through swaps is credit default swap.
What is a Credit Default Swap?
A credit default swap is a type of swap contract through which two parties swap their credit risk. Credit risk is the risk of a borrower defaulting on their payments on a given debt instrument. Through credit default swaps, investors can mitigate this risk by exchanging these risks with another party. For example, a lender can exchange the credit risk on their loan with another party if they think the borrower will default.
A credit default swap provides the lender protection against defaults from a borrower. Through these swaps, the lender buying the instrument can shift their risk to the seller. Credit default swaps work similarly to insurance policies. The buyer gets protection against any unforeseen events involving their debt instruments. In exchange, the seller receives periodic payments from the seller.
How do Credit Default Swaps work?
Credit default swaps come into play when buyers expect the credit risk on their instruments to be high. For example, a company issues bonds in the market. A few individuals and other companies purchase these bonds. Later, one of the borrower companies expects the issuer to default on the loan. Therefore, the borrower can acquire credit default swaps to mitigate the risk.
When the buyer purchases the credit default swap, the credit risk associated with the underlying debt instrument gets transferred. The swap seller agrees to bear this risk in exchange for regular payments from the buyer. This way, the buyer can mitigate the credit risk involved with the underlying debt instruments while the lender receives a steady income.
In case the bond issuer defaults on the debt instrument, the credit default swap seller must compensate the buyer. This compensation will include both the principal and interest payments on the loan. Therefore, the buyer gets protection against any defaults from the issuer. In contrast, if there is no default, the seller will collect regular payments from the buyer as an income.
What are the advantages and disadvantages of Credit Default Swaps?
The most prominent advantage of credit default swaps is that it provides lenders protection against credit risk. Usually, these risks come from high-risk instruments that promise high rewards. It also allows the seller to protect themselves through diversification. For the seller, the credit default swap provides a regular source of income.
However, credit risk swaps played a significant role in the 2008 financial crisis. It was primarily because of the unregulated nature of these swaps. Nonetheless, some regulations have been introduced for these derivatives since 2010. Similarly, credit risk swaps can be disadvantageous for the seller in case of default from the borrower. Credit default swaps can also cause lenders to invest in high-risk instruments, hoping the swaps would protect them against the risks.
Credit risk swaps involve the transfer of credit risk associated with an instrument to another party. Usually, the swap seller is a bank, insurance company, or financial institution that accepts this risk. Instead, the buyer makes regular payments to the seller. In case of default from the borrower, the seller has to compensate the buyer for the loan amount.