Critically examine the concept of Credit Default Swaps (CDSs). Analyze their structural features and evaluate the key purposes for which CDS…

CDS can be defined as an insurance (not in stricter sense) against the risk of default on a debt which may be debentures, bonds etc. Under this arrangement, one party (called buyer) needing protection against the default pays a periodic premium to another party (called seller), who in turn assumes the default risk. Hence, in case default takes place then there will be settlement and in case no default takes place no cash flow will accrue to the buyer alike option contract and agreement is terminated. Although it resembles the options but since element of choice is not there it more resembles the swap arrangements. Amount of premium mainly depends on the price of underlying and especially when the credit risk is more. Following are the main purposes for which CDS can be used: (i) Hedging - Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus, by buying CDS, risk can be passed on to CDS seller or writer. (ii) Arbitrage - It involves buying a CDS and entering into an asset swap. For example, a fixed coupon payment of a bond is swapped against a floating interest stream. (iii) Speculation - CDS can also be used to make profit by exploiting price changes. For example, a CDS writer assumed risk of default, will gain from contract if credit risk does not materialize during the tenure of contract or if compensation received exceeds potential pay-out.