The uses of credit default swap are mainly seen in hedging and speculative transactions. Similar to the majority of financial derivative products, the credit default swaps may be implemented for hedging the existent credit risk exposures or for speculating on the fluctuations of the credit spreads.
Credit default swaps may be utilized for handling credit risk free from the necessity of selling of the existing cash bond. The corporate bondholders have the option of safeguarding themselves from the risk of default through buying a credit default swap on the particular referred organization.
The speculators find an effective way of making a substantial amount of profit from variations in the credit rating or bond rating of a company. In case of a credit default swap, the protection seller efficaciously has exposure (unfunded in nature) to the existing reference organization or cash bond where the value is equivalent to the speculative amount of the credit default swap agreement.
Credit default swaps that are outstanding can also be bought and sold. Similar to the bonds, the price or expenditure for buying the swap from some other party can vary because of the reason that the anticipated credit rating of the company concerned also varies. Usually, the swap prices go down when the credit ratings of the company go up and the swap prices go up when the credit ratings of the company diminish. Nevertheless, these price variations are greater in volume in comparison to the bonds. Consequently, an individual who assumes that the credit ratings of a company will vary is able to earn increased amount of profit if he invests in swaps rather than bonds. Nevertheless, the investor might have to encounter an increased potential for loss.
If a particular company is experiencing problems related to debts, the speculators have the option to purchase the outstanding debt or bonds of the company on prices at a discount.
Last Updated on : 1st July 2013