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Explanation of CDS in simple terms

Fixed income securities are issued by a company to raise debt financing.  These are called corporate bonds and usually these bonds have a fixed coupon rate and a fixed maturity period usually 10 to 30 years. The coupon rates can also be variable and can be linked to any interest rate like LIBOR. An investor can subscribe to these bonds directly from the company at the time of initial issue or these can be bought from the secondary market. When an investor buys the bonds then the investor is subject to several kinds of risks as follows:

Interest rate risk

Fluctuations in the market interest rate will affect the market rate of the security. The interest rate and the market rate of fixed income security are inversely correlated. When the interest rate goes up, market rate of the fixed income security goes down and vice-versa.

Currency rate risk
Securities purchased in foreign currency are exposed to risk of fluctuations in foreign exchange rate. This will affect the effective yield of a security.

Issuer default risk

The issuer may default in the payment of interest and / or principal amount if the issuer faces liquidity crisis or files bankruptcy.

Issuer credit rating risk

The credit rating of the Issuer may undergo change and if it is downgraded the market rate of the security also will suffer to that extent.

An investor can take protection against each type of risk. There are hedging instruments available to cover the interest rate risk as well as currency risk. For the interest default or issuer bankruptcy risk the investor can buy protection and this form of protection is known as ‘Credit Default Swap’.

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