A credit swap is the colloquial term for a credit default swap or CDS, which is a credit derivative where the buyer pays a premium to the seller in exchange for the seller’s promise to pay out a given amount to the buyer if the underlying credit instrument fails to meet one or more outlined obligations.
The simplest way to understand a credit swap is as a form of insurance on bonds and other credit instruments.
The buyer of the credit swap pays an insurance premium and the seller acts as an insurer that must pay out when the underlying credit instrument fails to meet one or more obligations as outlined in the credit swap agreement.
Credit Swap Example
Suppose that an investor purchases a $10,000 corporate bond with a 10 year maturity and a 5% coupon rate. In this scenario the investor would receive $500 of interest each year for 10 years and the $10,000 principal after the 10th year.
Now suppose that the investor is unsure that the corporation issuing the bond will be able to meet its obligations. To control for this default risk, the investor agrees to a credit swap with a 3rd party, where the seller agrees to pay the buyer (the original investor) all the obligated coupon and principal payments in the event of a default or missed payment by the issuing corporation.
The seller charges the investor a premium of $250 each year for the duration of the bond as their price for offering the credit swap protection. This means that the investor will only gain $250 each year, as the original $500 per year profit from the coupon payment will be halved by the $250 per year premium payment that they must make to the seller of the credit swap.
Interestingly, there is no reason that a credit swap needs to be structured so plainly nor hew so closely to the structure of the underlying credit instrument.
For example, a credit swap could easily be structured so that the seller needs to pay the buyer 10 times the principal amount if the 4th coupon payment alone is missed.
However, the seller would then likely charge the original investor a much higher premium for such generous terms, perhaps $1,000 per year until the 4th year when the coupon payment in question is due.
Credit Swaps and Trading
Credit swaps are an excellent target for many day trading techniques, as they can exhibit periods of extremely high price volatility when their contracted terms are potentially going to be triggered.
That said, day traders without trading access to credit swap markets can still follow the progress of these markets, as they can often provide valuable insight and information about tradeable products related to the credit swaps.
Credit swaps are now a very important part of the modern financial landscape.
Despite the many negative connotations associated with credit swaps as a result of their role in the 2008 financial crisis, credit swaps have become a mainstay of modern investing, and their influence is likely to only increase over time.