Credit Default Swaps (CDS)

1. 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.
2. 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.
3. 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.
4. 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:

1. What Is a Credit Default Swap and How Does It Work? – Investopedia
2. Credit Default Swap (CDS): A Detailed Exploration of its Role in Finance

Feel free to explore these sources for further insights!