What is Credit Default Swap?

Do you have insurance? If then, half of my job here is done. Credit default swap (CDS)

is like insurance for bonds making sure you won’t be left with a bond worth price of an

ordinary paper. Like any insurance it may not be foreseeable in the future how the

bond turns out. But this will help you plan your finances and inch one step closer to

your financial independence.

The CDS is an agreement that protects the buyer (the person who bought the bond)

from the reference entity (company who issues the bond) not paying the amount

back. Seller (insurance provider) measures the probability of company not being able

to pay you your principle back after the maturity and charges a small amount of the

bond amount as their premium.

What are bonds and how they work? (Bond Basics)

Bonds are means for the companies to raise their required capital. Instead of raising

the total amount from a single person/ entity, the required amount is broken down to

smaller amount and these are bought by other people and companies. In return, the

issuing company pays each subscriber a small amount as interest till maturity and

gives the principal amount back after maturity.

If the reference entity is not able to pay you back, it is called as defaulting.

Where does insurers come in to picture?(Role of Insurers)

Consider this; you, an ardent football fan, has saved some money for the World Cup

2030. Since this money is just waiting for the day to come, you decide to invest in a

bond and save the interest as extra savings for the World Cup travel. But upon the

maturity of the bond in 2030, you get mail saying that the company went broke (too

many avocado toasts) and they won’t be able to pay you back. Your dream of

watching the WC has faded away.

This is where a protection seller (insurer) will help you keep your dream alive. You pay

a premium based on basis points, and the insurer pays your principal if the reference

entity defaults. The basis points move up and down based on many factors and

higher the basis point, higher the premium and higher the risk. The basis points are

mentioned as 100th of a percent. That is 100 basis point means 1% of principal amount

of premium to insure. Now thanks to the insurer you can start planning the itinerary for

your WC dream.

What can cause credit default?(Causes of Credit Default)

Lack of money for the paying you back is not the only event that the swap can

happen. Following are the most common credit default events according to the

International Monetary Fund:

• Bankruptcy: No resources with reference entity to pay the debts

• Failure to Pay: Reference entity can’t pay interests or principal amount

• Debt restructuring: Company changes the debt obligations that you as credit

holder is at disadvantage

Other events include:

• Obligation default: It is a situation where the reference entity fails to meet its

agreed terms of the bond. It can include failure to make interests, payment of

principal amount, violation of covenants or declaration of bankruptcy.

• Obligation acceleration: When suddenly you change your mind and want to

visit World Cup 2024, the reference entity is supposed to pay you back your

money in a short amount of time. If they fail to do so, it becomes default event.

• Repudiation: This occurs when the reference entity denies their obligation to

repay the debt.

• Moratorium: This is a delay in repayment caused by financial difficulties at the

moment. They may negotiate new repayment structure or other reliefs.

In a gist, CDS makes sure you get your money back after the maturity period if the

reference company defaults. There are many factors that can trigger default event

such as bankruptcy, failure to pay, and debt restructuring.

Hopefully this brought a better picture of what credit default swap is for you. Don’t let

this make buying bonds scary affair for you. Be aware and invest for your dreams. 

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