Question

What is a credit default swap? How does it indicate the probability of default of a company? Explain

Answer 1

Credit Default Swaps are the financial swaps agreement in which the sellers give a guarantee to the buyers of the credit Default Swaps that in case of default by a third party, Sellers are going to compensate the buyers for the losses. Sellers of Credit default swaps usually charge an amount of fee from buyers for providing them with such guarantee .

In other words, Credit default swaps are credit derivatives which helps in hedging of risks of default by a borrower.

Credit default swaps are highly complex instruments which are used by professional organisations after calculation of rate of possibility of default.

It indicates the probability of default by

= (Spread in CDS market/ Loss given default)

Probability of default originates from credit worthiness & credit risks coupled with default risks.