Credit default swap (CDS): protection against credit risk

Credit default swap (CDS) represents an innovative and sophisticated financial instrument belonging to the category of credit risk derivatives. It allows investors to protect themselves against the risk of default of a debtor, offering a hedge for possible losses in exchange for a periodic premium. In this article we will explore how CDS work, payment mechanisms, and benefits, highlighting its importance in managing credit risk for investors.

What is a credit default swap?

A credit default swap is a contract between two parties in which one, the protection buyer, pays a fixed periodic sum to the counterparty, the protection seller. In exchange for these payments, the protection seller assumes the risk of default by the borrower, intervening economically if an event of default occurs on the guaranteed credit. Unlike other similar instruments, the CDS does not require the parties to have a direct credit relationship with the underlying debtor: in fact, the contract is linked only to credit risk, not actual credit.

How the credit default swap works

The credit default swap involves a series of periodic payments that the protection buyer makes based on a rate defined in basis points and calculated on the notional principal amount. The amount of these payments is proportional to the debtor’s risk of default and is determined by the probability of default. The protection seller, in return, guarantees compensation should the debtor default.

Typical payment streams in a CDS include:

• Periodic payments from the protection buyer to the protection seller, generally determined by the credit risk of the issuer;
• Compensation in the event of default , which the protection seller must provide if the default event occurs.

Differences between credit default swap and credit default option.

Although often compared to the credit default option, the credit default swap has peculiarities that make it distinctive:

• In CDS, the protection buyer is the only one who makes the periodic payments;
• The payments are exclusively periodic and do not involve an initial premium, unlike other credit options.

These features make the CDS a versatile tool for credit risk management, with the main objective of providing constant protection without a high initial expense.

Practical example of using the credit default swap

Imagine an investor who has ten bonds issued by ten different issuers in his portfolio, each of which generates an annual flow of €100,000. Knowing the BBB rating of these bonds, and wanting to reduce the risk of default, the investor may decide to subscribe to a CDS. By doing so, he or she will pay a fixed sum each year, similar to an insurance premium, guaranteeing the right to receive a refund if one or more issuers fail to meet their payment obligations.

The CDS, in this context, allows the investor to mitigate the risk associated with credit quality and gain greater security with respect to future collections.

Benefits and considerations of credit default swaps

Credit default swaps offer multiple benefits for investors:

• Hedging against credit risk: CDSs act as an insurance instrument, offering compensation in the event of default;
• Flexibility: since the investor does not need to be directly linked to the borrower, CDS can be used in diversified portfolios;
• Active investor protection: CDS allows for increased safety of a portfolio, especially in volatile markets or when holding securities of issuers with high credit risk.

However, the use of CDS requires careful evaluation of the associated costs and risks. Although useful as a risk management tool, CDS involve periodic costs, and the effectiveness of hedging depends on the solvency of the protection seller.

Conclusion

The credit default swap is a powerful financial instrument for investors who wish to reduce their exposure to credit risk. Due to its structure, which provides periodic payments and protection in case of default, the CDS is suitable for various investment situations. Knowing how CDS works and its features allows investors to adopt more robust and targeted protection strategies, reducing risk without compromising their portfolio returns.

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