A credit default swap is designed in a way to transfer the credit exposure related with the fixed income products amongst the involved parties. In case of the credit default swap, the seller guarantees for the credit value of product while the buyer receives credit protection. This practice ensures the transfer of risk of default from the fixed income security holder to the swap seller. A credit default swap is also called CDS.
In other words CDS can also be defined as a bilateral contract that makes the two counterparties agree over trading credit risk involved with referred third-party entity, separately in isolation. A protection buyer under a credit default swap contract pays periodic fee to the protection seller.
The payment is made to the seller in exchange of the contingent payment made by the seller upon a credit event. In the cases when the credit event is triggered, the protection seller can go for two options � he can either pay the protection buyer the difference between the recovery value and par value of the bond known as cash settlement or even opt for the delivery of defaulted bond at its par value known as physical settlement.
In another words, it can also be said that a credit default swap is a specific kind of agreement allowing the transfer of credit risk of third party from one party to the other. Lender makes one party in the swap contract that is exposed to third party credit risk while the counterparty in the contract insures the risk over regular and periodic payments. In the cases when the third part defaults, the insurance providing party is liable to purchase the defaulted asset from insured party. The insurer party in return pays the principal and remaining interest on the debt to the insured party.
The use of credit default swap can be varied in nature. The credit default swaps are mainly used to speculate on the changes in credit spreads and also to hedge the existing exposures to credit risk. The credit default swap is used to handle the credit risk as the corporate bond owners can purchase a credit default swap by preventing themselves against default risk.
Last Updated on : 9th July 2013