Full form Of CDS

The full form of CDS is Credit Default Swaps. A credit default swap is a financial agreement that is done between the third party and the buyer. In this case, the seller ensures compensation to the buyer in case the acquired asset defaults for any reason.

CDS is also known as a credit derivative contract or instrument that is signed between two counterparties, i.e., the buyer and the third party, who agree to take the swap of the risk. A credit default swap is a very new concept and a highly complex mechanism. It can be enjoyed with the buyers only if it is genuine. Investors should take extra care before investing their money or before entering such contracts.

The Credit default swap is a derivative contract that gives the buyer the privilege to swap or transfer the credit risk to the third party. The buyer is required to pay some upfront fees to the party from whom they enter into a contract, and in return, the third party will protect the buyer in case of any default situation.

This financial instrument is commonly used by creditors who are not sure of getting back the money from the borrowers and wants to offset the risk of default. The lender, in this case, who buys the instrument has to pay the premium like that of an insurance policy, in exchange of which the seller of the instrument will compensate for the loss in case of default faced by the buyer of the instrument from their borrower. The payment continues till the maturity of the agreement.

The full form of CDS in banking, as mentioned above, instrument is widely used for hedging and speculation. In case of claim, the amount can be adjusted by payment of cash, or physical payment of the security. However, cash is always a preferred method of payment. However an important point to note is that is has  market value which keeps fluctuating, resulting in trading an profit-making opportunities from difference in prices.

At the time of the financial crisis, the CDS works as an insurance company for the buyer of that instrument since the sellers are required to compensate for the losses in that unlikely situation. The Credit default swap helps to transfer the credit risk from the buyer to the third party. With its special mechanism credit, the default swap is very popular nowadays.

Here are some notable characteristics of the concept of the full form of CDS in banking, as mentioned above.

• CDS is a derivative instrument that helps the buyers to shift their credit risk to the third party.
• It also acts as an insurance policy to the buyer since it promises to compensate the buyer through its sellers in case of any default.
• CDS helps the buyer to eliminate the possibility of loss or risk in the financial transactions, thus providing them encouragement to invest further.
• In this, the buyer will be provided with the face value of the loan in case of default, whereas the sellers are required to possess the loan in market value. This makes a huge difference in price.

There are four types of CDS.

1. Credit Default Swap on single entities.
2. Credit default swap on bulk entities.
3. First loss Credit default swap.
4. Credit default index swap.

Let us understand the concept with the help of a suitable example, as given below:

A company, XYZ Limited, has issued bonds in the market. There are many buyers to those particular bonds, and then the bonds have started to be issued publically. Somewhere the buyers were tensed about what if the company defaults in giving them return, so by that thought, the buyers enter into a contract of safeguarding the interest of the buyers in case of defaults, and this is called a credit default swap.

The following are the areas where CDS is typically used.

• It helps build confidence among the buyers that their interest is safeguarded and that they can invest in the market freely.
• CDS helps to manage the risk of the buyer.
• The companies can be relieved from the diversification if they opt for a Credit default swap.
• It helps the buyers to easily remove the liability or default amount of the loan from the balance sheet.
• CDS helps in easy transfer of the risk to the third party or the seller.
• Speculators use the difference in prices to trade and make profits.
• An increase in CDS spread is a sign of fall in creditworthiness, which instigates buyers. This, it also has the capacity to predict creditworthiness.
• It is also used for arbitrage where the trader buys it from one market and sells it in another at higher price, making profit. Stock prices are tracked in such cases because they are inversely correlated with swap spreads. In this case the trader profits if the company stock price falls, since the spread will widen.
• Banks also use it to hedge against loan default from the borrower. Not only default, but this instruments is also used to hedge against concentration risk, where one borrower has borrowed a huge amount of money.

Some of the common risks related to the concept are detailed below.

• It has been seen that the contracts of credit default swap between the parties are not legal sometimes.
• The government may not take any action against the seller in case the default occurs.
• If the buyers involve third parties like banks or insurance companies to pay off their debts, then it may so happen that the third party may also fail to help the buyer to compensate the amount from the sellers.

It is important to learn the advantages and disadvantages of the concept in details. Let us identify the advantages first.

• It is that it has a risk protecting provision to the buyers.
• The risk is transferred to the seller in case of default.
• The buyers will get the compensation from the seller as per the credit default swap agreements.
• The buyer will get encouragement to invest in risky investments, and thus the financial instrument can be more beneficial to the investors.
• In case of default, the buyer is free to remove the liability from their balance sheet.
• By using these swaps, companies can help themselves from diversification.
• The buyers get the protection by paying a very large amount as compared to the loan amount as premium money to the seller or the third party to whom they have entered into the contract.
• In case of default, the buyer will be compensated for the loan amount from the seller in the current market price and not the face value of the loan amount.

Here are some of the noteworthy disadvantages.

• The credit default swap can be misleading if they are not authorized, they may make premium money from the buyers, and ultimately the default occurs.
• They can be very discouraging for those who are opting to invest more money in the contracts.
• The third-party may, however, fail to make the compensation possible to the buyers in case the sellers default the payments.
• The risk associated can be very high in case the proper investigation is not done before entering the contract.

It is necessary to clearly identify the advantages and disadvantages of the concept so that it can be used in the appropriate place according to the needs and requirements of the situation.

• It is riskier than the interest rate swaps.
• In Interest Rate Swaps, the swap is done for the interest provision of any instrument, whereas in the Credit default swap, the swap is done for the loan amount of the instrument.
• In this swap, the buyers are given an assurance of compensation from the sellers, whereas, in the Interest Rate Swaps, this provision is not there.

This has been a guide to what is the Full Form Of CDS. We explain the types, role, characteristics, example, uses, risk, advantages & disadvantages. You may refer to the following articles to learn more about finance –

• Atomic Swaps
• Share Swap
• Equity Swaps
• Swap Rate