Prices for Credit Suisse default swaps rose to record new highs just before the bank was bought out. This was a clear indication that the market was very concerned that Credit Suisse were going to default on their debt obligations. In this article we discuss what are credit default swaps and how they are used by institutional firms in the market.
Definition
Credit default swaps are like an insurance product for buyers of fixed income products. It is a contract between two counterparties where in the event the issuer is unable to pay their debt obligations, then the credit default swap seller will pay the credit default buyer an agreed amount and the interest payments they would have been paid by the issuer.
For example, if a counterparty bought a Credit Suisse bond and also bought a credit default swap then if Credit Suisse fail their debt obligations, then the credit default swap should protect the buyer from a default as they should receive an agreed amount which includes the interest from credit default swap seller.
The credit default seller receives regular interest payments from the credit default buyer in exchange for the protection of the default of the issuer.
How are credit default swaps used in the market
As mentioned above credit default swaps are used to hedge positions. A counterparty may buy a bond and also a credit default swap as insurance in case the issuer defaults on the loan. This reduces their risk exposed to the issuer on the bond.
Credit default swaps can also be used by institutions to make money. If an institution believes a bond issuer has a solid credit rating and does not think they will default, they may sell credit default swaps to other counterparties. The seller of this credit default swap will collect regular interest payments for the life of the CDS contract and they are betting they won’t need to payout to the CDS buyer on maturity date.
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Institutions may use credit default swaps to trade as these financial instruments have changing market values. That is, they may buy a CDS and then sell a CDS to another counterparty at a higher price. There is no centralized market for credit default swaps, they are traded OTC (over-the counter) directly between two counterparties.
Lauren Hua is a private client adviser at Fairmont Equities.
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