A credit default swap is a financial strategy that aids in transferring risk from one party in the swap to another. The result is that while one party is somewhat insulated from events such as default, the other party takes on the credit default swap risk and continues to hold that risk until the investments related to the deal are settled in full. The amount of risk involved will vary based on the specifics of the asset used in the swap.
One of the more common types of credit default swap risk is the potential that the asset in question will fail and the holder of the asset will incur a loss. By engaging in a credit default swap, the holder is able to transfer that risk to the seller of the asset. For example, if the asset used in the swap is a bond, the holder can enter into this type of arrangement and essentially prevent losing the principal originally invested in the bond, even if the issuer defaults on the interest payments. The seller of the bond assumes that credit default swap risk and will bear the loss should the bond go into default.
Depending on the structure of the swap, the credit default swap risk may manifest as what is known as moral hazard. This simply means that the swap may carry some potential for a conflict of interest between the parties involved. Should some sort of loss be experienced, the seller may want to make the most of that loss as a means of using it to offset gains with other endeavors. This could leave the investor with less to show for his or her efforts, especially if the provisions of the swap still leave the investor open to at least a portion of that risk. In this scenario, one party wants to magnify the loss in order to use it to his or her benefit, while the other party may or may not receive any real benefits from the action.
Managing the possibility of credit default swap risk is something that any investor should consider before entering into this type of transaction. Since the goal is to keep losses at a minimum in the event some sort of default does occur, carefully crafting the terms and conditions related to the swap is extremely important. Taking the time to project events in which a default could occur and predicting the outcome of those defaults will provide a good idea if those provisions do protect the holder to a sufficient degree.
