Credit Default Swap

Definition

A Credit Default Swap (CDS) is a financial derivative that allows one party (the protection buyer) to pay regular fees to another party (the protection seller) in exchange for compensation if a credit event (such as default) occurs with a reference entity (such as a company or government). CDS are used to hedge credit risk or for credit speculation, commonly found in bond markets and credit derivatives markets.

Origin

Credit Default Swaps originated in the 1990s, initially developed by JPMorgan as a tool for managing credit risk. With the evolution of financial markets, CDS quickly became a significant credit derivative, especially during the 2008 financial crisis, where their importance and risks were widely discussed.

Categories and Features

The main features of CDS include credit protection, reference entity, credit event, and market trading. Credit protection refers to the protection buyer obtaining credit protection by paying regular premiums; the reference entity is usually corporate bonds, government bonds, or other debt instruments; credit events include default, bankruptcy, restructuring, etc.; market trading refers to CDS being traded in the over-the-counter (OTC) market, with customizable contract terms.

Case Studies

A typical case is during the 2008 financial crisis when AIG faced massive payouts due to selling a large number of CDS, ultimately requiring government bailout. Another case is during the Greek debt crisis, where investors used CDS on Greek bonds to hedge against potential default risks.

Common Issues

Common issues investors face when using CDS include misunderstandings of credit events, lack of market liquidity, and the complexity of contract terms. Investors should carefully assess the risks and benefits of CDS and ensure they understand the contract terms.