Background

Credit Default Swaps Explained

TLDR

Credit Default Swaps (CDS) is a financial instrument that acts like insurance on a loan. In exchange for a premium, the buyer of a CDS can claim the collateral should the covered loan default. The seller gets exposure to yield on their collateral in exchange for taking on the risk of the loan.

Example

Imagine Alice wanted to lend money to another person, Bob. Alice is worried that Bob might not be able to pay back the loan in the future. To protect herself from potential losses, Alice decides to enter into a credit default swap.

Alice finds another friend, Charlie, who is willing to take on the risk of Bob not repaying the loan. Charlie agrees to pay Alice a certain amount of money if Bob defaults on the loan.

In return, Alice agrees to make regular payments to Charlie, called premiums. These premiums are like insurance payments that Alice makes to compensate Charlie for taking on the risk.

Now, let's say Bob defaults on the loan and cannot repay Alice. As per the credit default swap contract, Alice can now make a claim to Charlie for the agreed-upon amount. Charlie will then pay Alice that amount, helping Alice cover her losses from the defaulted loan.

On the other hand, if Bob repays the loan successfully, Alice doesn't need to make any claim, and Charlie keeps the premiums that Alice had paid over time.

Credit default swaps are commonly used in the financial industry as a way to manage and transfer credit risk. They allow lenders, like Alice, to protect themselves against potential losses by transferring the risk to another party, like Charlie, in exchange for regular premium payments.

It's important to note that credit default swaps can be complex financial instruments, involving multiple parties and various terms and conditions. But at its core, a credit default swap is like an insurance policy that helps protect lenders from the risk of borrowers defaulting on their loans.