How can you use credit default swaps to hedge against credit risk?

1 What is credit risk?

Credit risk is the possibility that a borrower will fail to repay a debt or meet their contractual obligations. Credit risk can affect the value of your assets, such as bonds, loans, or receivables, and expose you to losses or impairments. Credit risk can also affect your cost of capital, as lenders and investors may demand higher interest rates or lower prices for your debt or equity.

2 How do CDS work?

A CDS is a type of derivative that allows you to transfer the credit risk of a reference entity, such as a corporation or a sovereign, to a protection seller. The protection buyer pays a periodic fee, called the premium, to the protection seller in exchange for the right to receive a payment, called the payoff, if the reference entity defaults or experiences a credit event, such as bankruptcy, restructuring, or failure to pay. The payoff is usually equal to the difference between the face value and the market value of the reference entity's debt.

3 How can you use CDS to hedge against credit risk?

You can use CDS to hedge against credit risk in two ways: by buying protection or by selling protection. If you own a debt instrument or an exposure to a reference entity, you can buy protection to hedge against the possibility that the reference entity will default or suffer a credit event. This way, you can reduce your credit risk and limit your potential losses. For example, if you own a bond issued by a corporation, you can buy a CDS on that corporation to protect yourself from the risk that the corporation will default on its bond payments.

Alternatively, if you do not own a debt instrument or an exposure to a reference entity, but you have a view on its credit quality, you can sell protection to profit from the premium income or the appreciation of the reference entity's debt. This way, you can increase your credit risk and enhance your potential returns. For example, if you think that a corporation has a low probability of defaulting or suffering a credit event, you can sell a CDS on that corporation to collect the premium payments and benefit from the increase in the market value of its debt.

4 What are the benefits of using CDS to hedge against credit risk?

Utilizing CDS to hedge against credit risk can offer a variety of advantages, such as the flexibility to customize the terms of the contract, liquidity in a large and active market, diversification of your portfolio, and efficiency in avoiding transaction costs and taxes. You can tailor the CDS contract to your needs and preferences, buy or sell protection on a wide range of reference entities and debt instruments without affecting their prices or availability, diversify your portfolio by buying or selling protection on different reference entities and sectors, and hedge against credit risk without having to buy or sell the actual debt instruments or exposures.

5 What are the challenges of using CDS to hedge against credit risk?

Using CDS to hedge against credit risk can also present some challenges. Counterparty risk involves the risk that the protection seller will default or fail to honor the CDS contract, thus not providing the expected payoff. To mitigate this risk, one may have to post collateral, pay a higher premium, or use a clearinghouse or an intermediary. Basis risk occurs when the CDS contract does not perfectly match the debt instrument or the exposure being hedged, leaving one not fully protected from credit risk. Market risk is also present and involves the risk of fluctuating market value of the CDS contract due to changes in interest rates, credit spreads, or other factors. This can affect cash flow, accounting, or capital requirements.

6 Here’s what else to consider

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