Credit default swaps are insurance-like contracts where a protection buyer pays an annual premium to a seller who covers losses if a borrower defaults. They're used to hedge against default risk or to speculate on whether credit risk is mispriced, and naked CDS (buying protection without owning the debt) may make up 80% of the market.
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What are credit default swaps? Although credit default swaps, or CDS, might sound complex, the basis of a credit default swap is actually very simple. Credit default swaps are a derivative financial instrument which protects the lender of money from borrower default. So let's say that you're an investor lending money to a company at a fixed annual interest rate. The main risk you have is that the company will go bankrupt and will not be able to repay the money that they have borrowed. So you buy a credit default swap from another investor who, in exchange for an annual premium, also known as a spread, will pay you the full amount that was lent in the event that the company defaults. Let's add a few details. Firstly, it's worth noting that the borrower, also known as the issuer, could be a company, government, or a bundle of assets which pay a fixed come to investors. These issuers are not directly involved in the CDS. Next, the buyer of the CDS is called the protection buyer, and whilst they own the underlying debt, they are said to be short credit exposure. On the other hand, the seller of CDS is called the protection seller. Although they do not own the underlying assets, are said to be long credit exposure. Credit default swaps are issued by investment banks and hedge funds and are bought by any investor owning the underlying asset. The premium or spread for a CDS tends to be less than 1% for investment-grade issuers and over 10% for distressed issuers. Now, the most obvious use of a credit default swap is as a protection against issuer default. However, CDS have provided investors with a unique tool for speculation. For example, if you have a high conviction that the credit quality of an issuer is better than the market's perception, you might wish to sell CDS, satisfied that the spread will more than compensate for the lower level of default risk. On the other hand, if you have a high conviction that the credit quality of the issuer is worse than the market's perception, you might wish to buy CDS in the expectation that the borrower will default and you receive a big payout. In order to effectively short a credit, speculators need to be able to buy CDS without owning the underlying debt. This is called a naked CDS. In fact, it is estimated that naked CDS account for account for up to 80% of the entire CDS market. Now, CDS do play an effective role in a well-functioning market and are more transparent and well-regulated than ever. However, the Great Financial Crisis taught CDS investors a very important lesson: investigate deeply the default risk of an issuer and make sure that in a black swan scenario, you are not overly exposed to default risk.
