🧙Credit Default Swap

This is the inspiration for the team to create GyroX

What Is a Credit Default Swap?

A Credit Default Swap (CDS) is a financial agreement between the CDS seller and buyer. The CDS seller agrees to compensate the buyer in case the payment defaults. In return, the CDS buyer makes periodic payments to the CDS seller till maturity.

And it allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.

CDS were invented so that the buyer could shift the burden of risk in case of payment defaults. It acts like an insurance policy wherein the buyer is supposed to make regular periodic payments to the seller. Typically, buyers swap to protect against the default of government bonds, corporate debt, and sovereign debt.

How Credit Default Swaps (CDSs) Work?

For example, if a company issues a bond, the bondholders bear the risk of non-payment. To hedge this risk exposure, bondholders could buy a CDS from a third party. This will shift the burden of risk from the bondholder to the third party. In return, the buyer of CDS pays interest periodically. Usually, these third parties are banks, hedge fund companies, and insurance companies.

To clarify, Sam buys a bond from FTX Ltd at a face value of $1,000 with a coupon rate of 10%. So Sam is supposed to receive $100 per annum ($1000*10%). Here, Sam bears the bankruptcy and the risk of non-payment by FTX Ltd. So, to shift the credit risk, Sam swaps with Caroline Enterprise. Caroline, in return, charges $20 per annum. Caroline Enterprise will pay Sam the principal amount of the bond and the coupon amount every year.

Now in case of no default, Caroline will end up making a profit of $20 per annum, and Sam benefitted by being risk-free.

Conversely, if it defaults, Caroline pays Sam the money he invested in the bond.