Credit Default Swaps

Credit Default Swaps or CDS are swaps designed to offer protection against credit risk of a country’s sovereign bonds or any other bond issuer. They are insurance for bond holders afraid to default.

The spread of a credit default swap can be viewed as a live risk indicator for the specific credit market. The CDS market reacts faster than the bond market hence serving as an excellent real-time market risk indicator.

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credit default swaps

The buyer of a credit default swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the debt security. In this way, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Sovereign CDS spreads can be used to read the forward-looking markets’ expectations of the credit worthiness of a country.

Typically to buy a $5 million bond requires $5 million. Through CDS it is possible to gain exposure to credit risk of bond without having to fund the bond purchase. To sell a bond, requires first borrowing it through repurchase agreement “repo” which is expensive.