Credit Default Swap (CDS)

I was reading at a research website from Bespoke Investment Group and came across an interesting article about Credit Default Swap (CDS). All this while, I have heard of this animal but was never interested to find out what it is. So this time I decided to find more about its meaning. I am sure everyone has read financial news related to CDS recently, so I think it’s good to understand it.

Below is the definition of Credit Default Swap (CDS) as written by InvestorWords:
A specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

The definition is quite long and complicated but it is actually easy to understand. Let me give a simple scenario relating to CDS. For example, John wants to borrow a sum of money from you and agrees to pay back the loan with interests at the end of a certain period. You wish to lend the money to John but you are afraid that John may go broke and you may not be able to receive back your capital. Therefore you will go to Insurance Company A and request for a CDS to insure against default of payment from John. Insurance Company A will assess credit rating of John and thus will charge you a premium for the insurance underwritten.

Well that’s roughly what CDS is all about. The interesting article that I was reading at the website of Bespoke Investment Group is about country default risk as measured by CDS prices. Guess which country came out top of the list? They are mostly the emerging countries and Argentina came out top.

Table courtesy of Bespoke