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To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults. Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk. It may involve bonds or forms of securitized debt—derivatives of loans sold to investors. Because the debt issuer cannot guarantee that it will be able to repay the premium, the investor assumes the risk.
The debt buyer can purchase a CDS to transfer the risk to another investor, who agrees to pay them in the event the debt issuer defaults on its obligation. Remember, the credit risk isn't eliminated. Rather, it is shifted to the CDS seller. Debt securities often have longer terms to maturity, making it harder for investors to estimate the investment risk. For instance, a mortgage can have terms of 30 years.
There is no way to tell whether the borrower will be able to continue making payments that long. That's why these contracts are a popular way to manage risk. In return, the CDS seller agrees that it will pay the CDS buyer the security's value as well as all interest payments that would have been paid between that time and the maturity date if there is a credit event.
Credit events are agreed upon when the CDS is purchased and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers: Reference entity default other than failure to pay: An event where the issuing entity defaults for a reason that is not a failure to pay Failure to pay: The reference entity fails to make payments Obligation acceleration: When contract obligations are moved, such as when the issuer needs to pay debts earlier than anticipated Repudiation : A dispute in the contract validity Moratorium : A suspension of the contract until the issues that led to the suspension are resolved Obligation restructuring: When the underlying loans are restructured Government intervention: Actions taken by the government that affect the contract Size of the Credit Derivatives Market Special Considerations When purchased to provide insurance on an investment, CDSs do not necessarily need to cover the investment for its lifetime.
For example, imagine an investor is two years into a year security and thinks that the issuer is in credit trouble. The bond owner may buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will fade.
Settlement When a credit event occurs, the contract may be settled physically, historically the most common method, or by cash. In a physical settlement, sellers receive an actual bond from the buyer. Cash settlement, though, became the more preferred method when the purpose of CDSs shifted from hedging tools to speculation. In this type of settlement, the seller is responsible for paying the buyer for losses.
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