CREDIT DEFAULT SWAP

Subject: Economics

Context: The Reserve Bank of India (RBI) will soon issue fresh guidelines on credit default swaps (CDS), a financial derivative instrument to hedge risks in bond investments.

Concept:

• A credit default swap (CDS) is a financial derivative or contract that allows an investor to “swap” or offset his or her credit risk with that of another investor.
• For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.
• Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.
• A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

Derivatives :

• Derivatives are financial instruments with a price that is dependent upon or derived from one or more underlying assets.
• Futures, Option , Swap represent the common form of
• An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract.
• In futures contract buyer has the obligation to purchase a specific asset, and the seller has to sell and deliver that asset at a specific future date.