What is a credit default swap?

Credit default swaps (CDS) are related to companies or government departments that have issued bonds in the capital market, but are not sold by these units.

The seller of CDS (a bank or other financial institution) receives regular payments (similar to insurance premiums) from the buyer in case the issuer of the bond fails to pay at maturity and therefore defaults.

Here's how it works: Suppose you hold a five-year bond issued by a Delta company with a face value of $1,000 and a coupon interest of $100 per year. However, you are also concerned that Delta may default on its bonds and have purchased Beta bank's CDS contract to be on the safe side. The bank charges you $20 a year until the Delta bonds mature and are paid in full or until the company defaults.

If the bond matures, you can cash in on that $1,000 face value and earn $500 in interest, less the $100 CDS contract payment paid to Beta Bank ($20 per year for 5 years).

Phronimos Group, in turn, assume that Delta defaults three years after the bond is issued. Under the terms of the CDS, the Beta bank shall pay you the face value of the bonds and the interest for the remaining two years, and the CDS contract terminates.

You do not need to hold a Delta Company's bond to buy the CDS contract for that bond. Suppose you have doubts about Delta's credibility and believe that the company is in poor financial condition and is likely to default, so you buy Beta bank's CDS contract, at that time, whether you hold the bond or not, the bank will still have to pay you the face value of the bond. These transactions are sometimes referred to as "naked credit default swaps".

Who is the winner?

If the bond matures, the CDS issuer benefits: the Beta bank in the example charges you $100 over five years, and you sacrifice a portion of the bond's proceeds.

If the bond defaults, the CDS issuer will lose money: you will receive a bond yield of $100 per year before the bond defaults, and the Beta bank will pay you the full face value of the bond and the remaining interest, that is, $200 (assuming the bond has two more years to mature). If it is a naked credit default swap, then you will only benefit if the bond defaults.