Question

B)

(i)Explain the mechanics of a standard credit default swap (CDS) using a diagram.

ii) Evaluate why CDS markets provide an important barometer of the creditworthiness of corporate bond markets.   

Answer 1

1)CDS or credit default swaps are a type of derivatives instruments or swap agreements entered between 2 parties where the seller of CDS promises the buyer to compensate for any loss from a credit default event from another party. The details of the credit event and the compensation to be paid are pre agreed between the buyer and seller and of the CDS position. Thus purchasing a CDS position by paying a premium acts similar to purchasing an insurance against credit default from another party. Here the buyer of CDS pays regular premium payments to the seller of CDS seller which is essential the spread on the CDS compensate the seller of CDS for taking the credit risk on the debtor which is called the reference entity for the CDS.  

2) Along with market and credit risk, CDS have high liquidity risk associated with them as the parties may not be able to liquidate their assets in time to pay for the pre agreed payments in the event of credit default.

In the event of market boom, the chances of credit default is less. Even if there are defaults, the CDS sellers are usually able to pay off the commitments from these defaults and thus

In the event of a global turmoil, every financial market participant will have a cash crunch and may not be able to honor their CDS payment commitments that they had earlier agreed on.

Thus a look at the CDS commitments acts as a barometer about the creditworthiness of corporate bond markets.Most of the recent global turmoil and recessions have been attributed to the over use of derivatives including the CDS products.