What Is A Credit Swap Agreement

If the borrower and lender are known and the market (or worse still the news media) learns that the bank is selling the loan, the sale can be seen as a signal of a lack of trust in the borrower, which could seriously damage the relationship between bankers and customers. In addition, the bank simply does not wish to sell or share the potential profits of the loan. By purchasing a credit risk swap, the bank can set up the default risk while keeping the credit in its portfolio. [9] The disadvantage of this coverage is that a bank without default risk may have no incentive to actively monitor the credit and that the counterparty has no relationship with the borrower. [9] A trader in the market might speculate that the credit quality of a reference company will deteriorate at some point and that it will purchase very short-term protection in the hope of taking advantage of the transaction. An investor may terminate a contract by selling his shares to another party, the contract by entering into another contract with another party or by clearing the terms with the original counterparty. As mentioned above, the purchaser of a CDS receives protection or profit, depending on the purpose of the transaction, if the reference unit (the issuer) has a negative credit event. If such an event occurs, the party who sold the credit guarantee and assumed the credit risk must provide the value of the principal and interest payments that the reference loan would have paid to the purchaser of the protection. Credit risk swaps are often used to manage the risk of default resulting from holding the debt. A bank may, for example, hedge its risk that a borrower may take out a late loan by entering into a CDS contract as a protection purchaser. If the loan is late, the proceeds of the CDS contract will cancel the losses on the underlying debt. [14] A CDS has two main uses, the first being that it can be used as a security or insurance policy against the default of a loan or credit.

An individual or entity exposed to significant credit risk may defer some of this risk by purchasing protection in a CDS contract. This may be preferable to selling the guarantee if the investor wants to reduce the risk and not eliminate it, avoid a tax burden or simply eliminate exposure for a specified period of time. Credit risk swaps allow investors to speculate on the evolution of CDS spreads of individual names or market indices such as the North American CDX index or the European iTraxx index. An investor might believe that a company`s CDS spreads are too high or too low relative to the company`s borrowing rates and try to take advantage of this view by engaging in a trading known as core trading and combining a CDS with a cash loan and an interest rate swap.

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