CDS: Hedging of Issuer and Counterparty Risks

Abstract

Credit derivatives have a broad range of applications throughout the capital markets, for portfolio managers, traders, and investors alike. The favourably liquid nature of these products, which translates into low transaction costs, contributes to their broad acceptance. CDSs are used for hedging credit risk, managing of economic and regulatory capital, speculative or proprietary trading, synthetic (or unfunded) investments, pricing credit risk assets, and capital-structure arbitrage and as a gauge for credit risk through market implied ratings (MIRs) or Early Warning Systems (EWSs). The single name credit default swap is a widespread form of transferring credit risk from the protection buyer to the protection seller and is often compared to an insurance contract. As with insurance, a premium has to be paid for compensation of potential future losses from a specified event occurring to the insured item. However, there are substantial differences, too. One of the arguments against CDS as insurance points to the fact that any payout under insurance is conditional on the holder owning the insured object or at least experiencing losses caused by the insured event; this is not true for a CDS.