Credit Default Swap Agreement
CDS is the abbreviated form of Credit Default Swap contract. The contract gains its worth due performance and the quality of credit of a given asset. The contract refers to an accord between a seller and a buyer that ensures getting back the asset, should there be any default. So, CDS is a sort of insurance for a debt.
The basic information
A seller and a buyer can make a credit default swap in private market. The party selling the CDS ensures getting back a specified security, should it default. The party buying the CDS pays the seller till the expiry of the security or its default. Bond markets frequently make use of CDS. These pledge the arrears of a specified firm or securities with government backing.
The idea at the back of designing credit default swaps was to provide hedge to the risk associated with accepting debt securities. It means that one could buy a bond and purchase also a corresponding CDS, should the borrower turn defaulter and be unable to pay. Of course, it reduces the return you get as you need to pay the seller of that CDS, but it significantly reduces your risk. Financial experts are of the view that CDS lowers the expense of borrowing since it enables the lender to circumvent their bet without asking for increased payment towards interest.
The one selling CDS is exposed to long term risk posed by the borrower. That means the one selling the CDS continues to expect that the party issuing the debt won’t default. In exchange, the selling party makes money from the payment it receives for offering this kind of insurance. Those selling CDSs need to have sufficient funds in more than a few defaults take place so as to avoid getting into trouble.
A naked purchase is one that involves buying of CDS minus the possession of essential security. Acceptance of naked bets is a vital matter in CDS market as such bets point out your speculative attitude towards the company. It is no more treated as hedging. It is tilted towards forecasting failure of the company to pay back its debts. Adversaries claim that speculators manipulate to bring down the value of debt and that raises the cost at which the company may borrow and thus cause financial harm to the company. Advocates of naked purchases claim that speculators, being smart in handling such money matters, keep the markets very competent.
Credit default swaps had a role to play in the monetary disaster that started in 2008. A number of insurance companies and banks like AIG sold substantial amounts of CDS. As firms like Lehman Brothers began failing, institutions like AIG, among others did not have adequate funds for paying every CDS, which they had guaranteed. It won’t be wrong to say that CDSs alone caused the down fall of AIG. Nevertheless, unlike other monetary instruments, CDS market continues with its business and plays an important role in shaping global economy.