CREDIT DEFAULT SWAPS
Updated: Jul 22, 2020
There are innumerable types of financial securities being traded all across the globe in different forms like equity, commodities & derivatives on different exchanges legally and illegally (grey market). CDS unlike equity securities is a derivative. A derivative is a financial security that derives its value from underlying assets or a combination of them. For example: the quality of an ice-cream depends upon the quality of the milk used in it, thus ice-cream’s value is reliant on its underlying ingredient i.e. milk. Similarly, CDS relies on its underlying asset for its performance. Underlying assets for derivatives could be bonds or Asset-Backed Securities (ABS). ABS is a pool of loans that are then repackaged and sold to people as a new security. To exemplify ABS, think of Amul Ltd which collects milk from various local farmers, processes it, and then repackages in different forms like Amul milk, lassi, dahi etc. along with the use of other products. Types of ABS could be residential mortgage loans (MBS), commercial mortgages, auto loans & student loans.
Swaps are a sub-category of derivative which is often used to exchange one kind of cash flow with another. Credit Default Swaps are simply like an insurance contract. It refers to anticipating that a certain business entity will default on its credit thereby giving an opportunity to make money by betting on its probability. It is an agreement between two parties where one party pays fixed regular payments (like insurance premium) to the other party who then ensures the credit risk of the reference entity (bonds or ABS). If the entity defaults on its credit, the risk of the buyer is swapped or offset by the premium payments made to the seller and he is insured against such risk by the seller.
Let’s take a real-life example: The core reason for the 2008 financial crisis was non-payment on home mortgage installments by borrowers leading to a default on mortgage-backed securities (MBS).
The whole housing market collapsed due to poor background checks and almost no rejection of applicants for a housing loan. Experts who anticipated this fall bought CDS where in exchange for monthly premium payments banks will pay them a proportionate amount if these MBS defaults. Banks expected the borrowers to pay their mortgage payments but default rates increased from 2% to 8% herald marking the worst-hit global financial crisis. The only people making a profit in this crisis were the ones who bought CDS as their prediction was right and their risk was duly insured by banks.