The participants in the world’s financial markets are constantly innovating to create new investment strategies. Sometimes, their innovations give rise to new financial products. An example of this is the invention of credit derivatives, a class of financial instruments that includes credit default swaps. A credit default swap spread is a measure of the cost of eliminating credit risk for a particular company using a credit default swap. A higher credit default swap spread indicates the market believes the company has a higher probability of being unable to pay investors, which means it would default on its bonds.
Credit risk is the risk that a borrower will not be able to repay a loan. In the bond market, credit risk is the same as default risk. When an investor buys a bond, the company borrows his money; it will repay him in the amount of the face value of the bond when it matures. He has only the guarantee of the issuer to back up the bond payment, however, so if the company is unable to meet its obligations then he loses the money he paid for the bond. This means he is subject to credit risk.
Traditionally, bond investors relied on the ratings given to bonds by agencies like Moody’s and Standard & Poor’s to get information about the credibility of bond issuers; even then, they were subject to some risk of default even if they invested in bonds with the highest ratings. When the first credit default swap contract was created in 1998, a new market was born on which investors could trade instruments that would protect against credit risk. This market has two functions. It allows investors to trade credit derivatives to protect against credit risk or to try to profit from a company’s viability. It also created an environment in which the combined wisdom of investors could put a price on credit risk protection, giving fine-tuned information about market expectations of a company’s reliability.
A credit default swap is an arrangement between two parties. The buyer holds bonds issued by a company, and he is trying to protect himself against credit risk. The seller agrees to bear the credit risk in exchange for payments from the buyer. If the company in question defaults on its bonds, which is called a credit event, then the seller has to buy a predetermined amount of the company’s bonds from the buyer at their face value.
A credit default swap spread is a way of reporting the rate for protection against a particular company’s default risk. The figure reported is for annual protection, and it is measured in basis points, which are equal to one one-hundredth of one percent. If the credit default swap spread is 500 points, for example, an investor would have to pay five percent of the face value of his bonds per year to secure the ability to sell his bonds at face value after a credit event.