Source: B&B Structured Finance Ltd |
As credit default swaps isolate and transfer credit risk, users can buy and sell protection depending on whether they want to hedge (or in some cases speculate) or take on credit risk. Since sellers of protection take on credit risk and earn a premium for this risk, they are equivalent to the buyers of bonds. And since buyers of protection hedge credit risk – paying a premium for getting rid of risk – this is equivalent to shorting a bond. In both cases, the party taking on credit risk loses money if the credit defaults.
The main difference between bond and credit default swap cashflows is timing of principal payments. The bond buyer pays the principal to buy the bond on the trade date, whereas the protection seller pays the principal (or rather, principal less the recovery rate) only when the credit defaults.
Credit default swaps are therefore leveraged instruments because the protection seller does not need to put any money down to earn a premium for the risk it takes. Credit default swaps are also referred to as unfunded instruments, since the protection seller – unlike the bond investor – does not need to raise money (or get funding) to buy credit risk.
Credit default swap cashflows mean that the protection buyer is exposed to the credit risk of the protection seller. This ‘counterparty risk’ is the risk that the protection seller cannot or will not pay the par amount, at the time when the protection buyer needs it most. By contrast, the protection seller’s only counterparty risk is that the protection buyer will stop making premium payments.