Let’s Understand Credit Default Swaps (CDS)
The financial markets use many complex tools, and one of the most talked-about tools is credit default swaps. Their name may sound complicated, but the idea behind it is very simple.
What is credit Default Swaps
(CDS)
It is a type of financial tool
that is use to cover the risk of default by other party.
In simple words we can say that
it is an extra yield or premium demanded by lender from borrower to lend money
when if it is a risky borrower. Here the parties may be governments of
countries and big investment banks or financial institutions.
or jayada simple language me
aise samjho ki “agr main kisi aise insaan ko udhaar paisa deta hu jo ho skta
hai muje paisa vapas na de to main usse jyada interest ya premium charge
karunga qki uska market me credit ach nahi hai and use paisa udhaar dena risky
hai”.
Breaking the words
Credit -
Lending money as loan
Default -
Failure to pay back the loan
Spread -
Difference in interest rates
Understand with an Example:
Let’s say:
• A
U.S.A. government bond gives 2% interest. As it is safe investment.
• A
company bond gives 6% interest. As it riskier because it has different type of
risk.
Then the credit default spread
is:
6% - 2% = 4% (we are getting 4%
extra for bearing the extra risk that company might not pay back in that case
default risk is there and 4% is extra for default risk)
Where is it Used?
Credit default spreads are used
in:
Bond markets – CDS used to
compare how risky different companies or countries are.
Credit derivatives – credit
derivatives are also like Credit Default Swaps where investors can
"insure" themselves against the risk of a company non-payment.
Investment analysis – CDS helps
to decide which bonds to invest on the basis of risk and return.
In other words, whenever companies, banks, and investors lend money to buy bonds, there's always the risk of default. Default means the borrower fails to pay the principal and interest. To mitigate this default risk, investors use CDS as protection or hedge. This provides them with peace of mind.
Basic Terms You Should Know
Before exploring into something more Understands
the basic terms
Buyer of CDS - The person who
wants protection
Seller of CDS - The person who
provides protection
Reference Entity - The borrower
(company or government)
Premium - The regular payment
made for protection
Credit Event - When the borrower
defaults
Is CDS Like Insurance or Hedge?
This is very similar to
insurance but there is one important difference.
In normal insurance, you need to
own the asset you are insured for but in CDS you dont need to own the bond to
buy protection. This means even people who did not lend money can buy CDS to
make profit if the company fails.
Why is CDS Important? –
Risk Management –
Banks and investors use CDS to protect themselves from losses if a borrower
fails to repay a loan.
Price Discovery – The
CDS premium (or spread) shows how risky a company is considered to be. If the
premium is high, it means the market believes the company has a higher chance
of default.
Market Stability (in theory) – By
transferring risk from one party to another, CDS can help make the financial
system safer. However, if used too much or without proper control, it can also
create serious problems.
CDS and the 2008 Financial
Crisis
Credit default swaps became very
famous during the 2008 crisis. Many banks and institutions used CDS heavily.
One major example was Lehman
Brothers, which collapsed in 2008. When Lehman Brothers failed, large CDS
payments were triggered. Many banks and financial institutions suffered huge
losses, and the entire financial system became unstable.
Another
important example was AIG (American International Group). AIG had sold a large
number of CDS contracts but did not have enough money to cover the claims. When
many borrowers started defaulting, AIG faced massive losses and was close to
bankruptcy. The U.S. government had to step in and provide financial support.
This crisis proved that if Credit Default Swaps are not properly
managed and regulated, they can increase risk across the entire financial
system.
Is CDS (Credit Default Swap)
tradable in India?
Yes, CDS is tradable in India —
but with restrictions.
In our country India, Credit
Default Spread are allowed to trade but the market of CDS is regulated by RBI
Reserve Bank of India and also have strict rules.
In 2011 first time RBI has
issued its first Credit default Spread guidelines after that revised these
guidelines in 2022 to make the market more flexible and transparent.
Who can trade CDS in India
Only institutional investors
& traders allowed to trade, As, mention earlier it is regulated & has
strict rules to follow no one can use it for speculation or profit making, only
hedging can be done by CDS. All transactions must follow RBI rules.
Can an Individual investor trade
CDS in India?
The Answer is No,
• Individual
investors are not allowed to trade or buy CDS in India.
• It’s generally a financial instrument for big institutions to manage risk.
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