What is a Credit Default Swap
Credit default swap is a commonly used credit derivative. This swap safeguards the buyer of the risk of loosing money in case a default is made in a loan that he has given to a third party. The swap is exchanged between the credit provider and another person. The credit default swaps started in the mid nineties and have become very common these days.
The credit default swap means that the seller of the swap will compensate for the loss made by the buyer of the swap if another person makes a default in repaying the loan amount. This will safeguard the buyer from the risk of default. It will shift the risk from the buyer to the seller. The seller will also not do it for free. There will be counter side to the credit default swap.
The buyer of the swap has to pay the seller a regular compensation that is a series of payments have to be made for the seller to compensate for the default loss. If the default does not take place then the seller of the credit default swap makes a huge profit. All the payments that he has received from the buyer will be his profit. But incase there is a default the seller has a huge risk on his head to compensate to the buyer.
The buyer on the other hand has lesser risk in any case. Most of the buyers of the credit default swaps are hedgers who are often exposed to a lot of risk. They would want to reduce the burden of risk and diversify the risk by buying such swaps. General speculation and trading is also done on the credit default swaps. Speculators are in the credit default swaps market for a short period of time but can change the form of the market completely.
Many people compare the credit default swaps with that of an insurance contract. This is because there are several common factors between the two such as minimizing the risk on happening of an event. But in real terms there are many differences between the two. The most obvious difference is that the insurance company is a regulated entity where as the seller of the credit default swap can be anybody.
The second point of difference is that the buyer need not have an insurable interest in the product where as in the case of the insurance company it is necessary and a collateral needs to be there. There are various shortcomings in the derivative but over time it has proved to be a worthy hedging tool and useful for portfolio management.