Credit Default Swap (CDS), also known as loan default insurance, is a financial derivative instrument combining credit and insurance. It is a contract that allows investors to hedge credit risk. The CDS buyer periodically pays a fee (called the "spread") to the seller in exchange for the right to receive compensation if a specific credit event (such as bankruptcy or payment default) occurs to the reference entity (usually the bond issuer).
CDS Functions
Hedging Credit Risk: Investors can hedge the credit risk of their bond or loan portfolios by purchasing CDS, reducing potential losses. CDS allows the transfer of credit risk from risk-averse parties to participants with greater risk tolerance or willingness to take on risk for potential gains.
Speculative Trading: Investors can use CDS to express their views on the creditworthiness of specific entities, engaging in speculative trading by buying or selling CDS to seek potential profits.
Risks of CDS
Counterparty Risk: The seller may be unable to fulfill their obligation to compensate in the event of a credit event.
Liquidity Risk: It may be difficult to find a suitable counterparty to close out a position under market stress.
Systemic Risk: The widespread use of CDS may lead to the spread of risk throughout the financial system, exacerbating financial market instability.
CDS is an important credit risk management tool, but it also carries its own risks. Investors participating in CDS transactions should fully understand its characteristics and risks, and make prudent decisions.
