Sovereign credit default swaps investopedia forex
Interest rate and credit default swaps are speculative contracts between organizations. What Are the Benefits of Interest Rate Swaps? Interest rate swaps and credit default swaps are sophisticated financial sovereign credit default swaps investopedia forex techniques.
Although their names are similar, these investment tools have little in common. Differences exist in the features and purpose of interest rate and credit default swaps, as well as the types of organizations that engage in each. Both instruments carry a different set of inherent risks, as well. Features In an interest rate swap, companies agree to trade interest rate provisions by allowing each other access to each others’ credit arrangements.
Companies that wish to trade a fixed interest rate for a variable interest rate, or vice versa, engage in interest rate swaps with other companies to take advantage of the favorable terms offered to their swap partner. Credit default swaps are essentially a form of default-risk insurance. Companies holding fixed-income securities, such as municipal bonds, purchase credit default swaps from banks and other financial institutions. The swap purchaser pays a regular premium to the seller in return for a guarantee of payment in the event the fixed asset turns sour. Purpose Interest rate swaps are performed to lower the cost of credit by taking advantage of another company’s credit lines. Each interest rate swap must involve two parties, each of whom wishes to utilize the interest rates enjoyed by the other. Credit default swaps serve two purposes.
The most basic purpose is as a form of insurance, as mentioned, to protect against the risk of default on fixed-income securities. The seller of a credit default swap counts on the seller of the security to make good on his payments, allowing the swap seller to collect premiums without incurring any financial obligations. Investors also use credit default swaps as a trading and profit-generating technique. Because these instruments are traded over the counter, there are very few restrictions on trade. Investors can purchase credit default swaps on debt that someone else holds, betting that the asset will fall into default. Swaps can also be traded among investors to reap marginal profits. Risks Interest rate and credit default swaps present unique risks to both parties.
Credit default swaps carry more systemic risk, making them a much more sophisticated investment. If economy-wide default becomes a problem, swap issuers may find themselves unable to meet all of their swap obligations, damaging investment portfolios and creating ripple effects throughout the economy. If default swaps are traded too prolifically, swap holders may find it challenging to ascertain the original swap seller. About the Author David Ingram has written for multiple publications since 2009, including “The Houston Chronicle” and online at Business. As a small-business owner, Ingram regularly confronts modern issues in management, marketing, finance and business law.