What is a credit default swap?

Credit default swap acts as the insurance policies. It is a financial derivative which allows an investor to offset their credit risk with that of other investors. In this swap, the buyer will pay quarterly installments to the seller. It protects against high-risk corporate debts, municipal bonds and sovereign bonds.

It is an agreement between protection buyer and protection seller. In this, any loss of buyer from credit event (bankruptcy, restructuring etc.) in reference instrument is compensated by protection seller. In case of default, the seller will pay bond face value to the buyer.

Formula

The formula to calculate the credit default swap is explained below −

Payout amount = notional amount * percentage of bond’s par value/payout ratio
Or
= notional amount * (1- percentage amount owned which is recovered by bondholder)

Varieties

The varieties in credit default swaps are listed below −

• Binary credit default swaps.
• Basket credit default swaps.
• Contingent credit default swap.
• Dynamic credit default swap.

Uses

The uses of credit default swaps are mentioned below −

• Investors buy credit default swaps to get protection from speculations.
• Determines entities’ creditworthiness.
• Used as arbitrage (buying in one market and selling in another market).
• Hedge against risk.

Risks involved

The risks involved in credit default swaps are as follows −

• Default on contract
• Sometimes leads to loss (due seller force buyer to sell).
• Jump to jump risk.