Credit Default Swap : Definition, Structure, Use, and Potential Misuse
Credit
default swaps and credit derivatives in general are one of the many specialized
derivatives that are used for the purpose of hedging, speculation and
arbitrage. The primary purpose of a credit derivative or the need behind the
creation of such a product is to serve as a credit risk transfer mechanism.
Credit risk is one of the four broadly classified types of risks (others being
operational risk, market risk and liquidity risk) is the possibility of a loss
resulting from a borrower’s failure to repay a loan or meet contractual
obligations. Credit Default Swaps and Credit Derivatives gained popularity in
the pre and during Global Financial Crisis in 2008. It has earned a bad reputation
since then as it is perceived as one of the most dangerous financial
derivatives. The decline in trading volume of emerging market sovereign CDS in
the years since the 2008 global financial crisis, along with the steady rise in
volume of emerging-market-bond ETFs, might have contributed to this increase in
the relative efficiency of bond-price discovery.
Credit-Default
Swaps (CDS) were generally a better source of price discovery than spreads
computed from bond prices. Credit-Default Swaps (CDS) tended to be a better
measure of value compared to spreads computed from bonds, which may have been
traded infrequently. However, since the COVID-19 crisis, the cash bond market
appears to have made strong inroads as the better source for investors to compare
relative value and risk.
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