- What Is a Credit Default Swap?
- A credit default swap (CDS) is a financial derivative that enables investors to transfer or offset credit risk with another party.
- In a CDS contract, the buyer pays an ongoing premium (similar to insurance premiums) to the seller.
- In return, the seller agrees to pay the security’s value and interest payments if a credit event (such as default) occurs1.
- How CDSs Work: An Example
- Suppose an investor holds a corporate bond with a face value of $100 and a 10-year maturity.
- The bond issuer promises to repay the $100 at maturity, along with regular interest payments.
- However, the investor faces the risk that the issuer may default.
- To manage this risk, the investor can purchase a CDS from another party. If the issuer defaults, the CDS seller compensates the investor1.
- Market Factors Influencing CDS Pricing
- Business Cycles: Economic conditions impact credit risk. During economic downturns, default risk increases, affecting CDS prices.
- Geopolitical Issues: Political instability or global events can alter credit risk perceptions.
- Monetary Policy: Central bank actions influence interest rates and credit spreads.
- Market Sentiment: Investor confidence and market volatility play a role in CDS pricing2.
- Market Data and Risk Parameters
- Participants gather relevant data, including credit spreads, yield curves, and market indicators.
- These inputs help determine the fair value of CDS contracts3.
Sources:
- What Is a Credit Default Swap and How Does It Work? – Investopedia
- Credit Default Swap (CDS): A Detailed Exploration of its Role in Finance
Feel free to explore these sources for further insights! 😊
