Before talking about CDS i.e. Credit Default Swaps, let’s talk about what a swap agreement is. A swap agreement refers to an exchange of a financial instrument for another between two parties. There are various types of swap agreements Interest rate swap, Currency swap, commodity swap, and many more.
Credit Default Swap (CDS) is a credit derivative, but a swap instrument. A credit derivative allows the creditor to transfer the risk of the debtor's default to a third party, paying it a fee to do so. A CDS is an agreement through which an investor can offset his credit risk with another investor.
Let’s understand how CDS works, here one party sells the risk and the other buys the risk. Here the seller is selling risk protection and protecting the buyer from default risk of an underlying asset, it can be municipal bonds, mortgage backed securities, corporate bond or any other fixed income security. Since the buyer is being protected by the seller, the seller receives a premium from the buyer. This works just like an insurance policy.
For example let’s say Mr. A owns some corporate bonds, but is afraid that the bond might degrade or default. So he enters into a CDS agreement with Mr. B, now Mr. A will pay premium to Mr. B and in return in case the bonds degrade or defaults will be covered by Mr. B.
One of the most important reasons of understanding CDS is its impact in causing the 2008 financial crisis. Lehman brothers firm had around $400 billion debt which was covered by CDS, companies like AIG (American international group), Pacific investment management company, and Citedal hedge fund. Lehman brothers declared bankruptcy and AIG weren’t ready with sufficient cash in hand to cover the swaps contracts. The Federal Reserve came to rescue and bailed them out. To make matter worse the banks had entered swaps to insure bit more complicated financial products which they traded in unregulated markets. The CDS markets crashed overnight, now no one was buying them as people were now aware that companies selling swaps weren’t able to cover large defaults.
Let’s look at the possibility of using CDS in India to recover or to boost the economy post covid-19. As we know corporates and government will require huge capital to recover from such an economic stress, they can fulfil the funds requirement by issuing bonds. But as we know there will be a lot of risk in investing in such bonds, but if there is an authority that can cover the investors by giving CDS, the number of investors could be increased and a greater volume of investment can be raised. The only problem is how to form such an authority, here corporate and public banks can come together and fund to incorporate a CDS selling firm backed by RBI. This way they can mitigate risk and ensure smooth functioning. Only concern will be what if the bonds default, RBI will have to deal with the rising NPA if not with CDS defaults. Here if defaults are not large spread then RBI and government with the help of banks can manage the loss and make sure that it doesn’t impact the economy to greater extent.
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