Credit Default Swaps

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Context:

Securities and Exchange Board of India (SEBI) announced that mutual funds can now sell credit default swaps (CDS) citing the need to aid liquidity growth in the corporate bond market.

What Is a Credit Default Swap (CDS)?

A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor.

It may involve bonds or forms of securitized debt—derivatives of loans sold to investors.

To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.

How Credit Default Swaps (CDSs) Work

A credit default swap is a derivative contract that transfers the credit exposure of fixed-income products.

For example, suppose a company sells a bond with a $100 face value and a 10-year maturity to an investor. The company might agree to pay back the $100 at the end of the 10 years with regular interest payments throughout the bond’s life.

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Because the debt issuer cannot guarantee that it will be able to repay the premium, the investor assumes the risk. The debt buyer can purchase a CDS to transfer the risk to another investor, who agrees to pay them in the event the debt issuer defaults on its obligation.

Instances where CDS are used:

As an insurance policy against a credit event on an underlying asset, credit default swaps are used in several ways.

Speculation

Because swaps are traded, they naturally have fluctuating market values that a CDS trader can profit from. Investors buy and sell CDSs from each other, attempting to profit from the difference in prices.

Speculation is the act of buying an asset with the expectation that it will increase in value shortly. It can also refer to short selling, where the speculator hopes the value will decrease.

Speculation can be risky, as speculators may focus on price movements rather than the fundamental value of the security.

Hedging

Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.

A credit default swap by itself is a form of hedging. A bank might purchase a CDS to hedge against the risk of the borrower defaulting. Insurance companies, pension funds, and other securities holders can purchase CDSs to hedge credit risk.

Arbitrage

Arbitrage generally involves purchasing a security in one market and selling it in another. CDSs can be used in arbitrage—an investor can purchase a bond in one market, and then buy a CDS on the same reference entity on the CDS market.

Disclaimer: Copyright infringement is not intended.

Important articles for reference:

Currency Swap

Mutual funds

Exchange Traded Funds

SEBI

Sources:

https://www.thehindu.com/incoming/sebi-allows-mfs-to-sell-credit-default-swaps-to-boost-corporate-bond-liquidity/article68664811.ece

https://efinancemanagement.com/derivatives/hedging-vs-speculation

https://www.investopedia.com/terms/c/creditdefaultswap.asp

PRACTICE QUESTION Q.Consider the following pairs: Speculation It is an important financial concept that allows investors and traders to minimise various risk exposures. Hedging It is the act of buying an asset with the expectation that it will increase in value in the near future. Arbitrage It involves purchasing a security in one market and selling it in another. How many of the above pair(s) is/are correctly matched? A.Only one B.Only two C. All Three D.None Answer: A Explanation: Pair 1 is incorrectly matched: Speculation is the act of buying an asset with the expectation that it will increase in value in the near future. It can also refer to short selling, where the speculator hopes the value will decrease. Speculation can be risky, as speculators may focus on price movements rather than the fundamental value of the security. Pair 2 is incorrectly matched: Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. A credit default swap by itself is a form of hedging. A bank might purchase a CDS to hedge against the risk of the borrower defaulting. Insurance companies, pension funds, and other securities holders can purchase CDSs to hedge credit risk. Pair 3 is correctly matched: Arbitrage generally involves purchasing a security in one market and selling it in another. CDSs can be used in arbitrage—an investor can purchase a bond in one market, then buy a CDS on the same reference entity on the CDS market.