Profit From Credit Default Swaps

If you spend much time reading about the bond market, you'll come across articles mentioning credit default swaps. It's clear that they're important, but it can be hard to figure out exactly what a credit default swap is.

In general, these financial instruments are privately negotiated contracts between institutional investors which are based on corporate bonds. They can be written for individual issues or for baskets and portfolios of credits and index trades.

Swap basics
Bonds have two primary risks that can affect their value. Credit risk involves the possibility that the issuer won't make payments to its bondholders, whereas interest-rate risk deals with the fact that if rates rise, then the value of most bonds will fall.

Essentially, credit default swaps allow parties to separate credit risk from interest-rate risk, meaning they can transfer one part of the risk while retaining the other. Specifically, the purchaser of a credit swap receives protection against the issuer defaulting on payments, while the seller guarantees those payments with its own funds. In a "plain vanilla" transaction, the buyer of a swap is entitled to receive the par value of the bond from the seller of the swap if a default occurs in the bond's coupon payments.

A growing market
Credit default swaps represent one of the fastest-growing derivatives markets. Dealing in these derivatives began in 1994. According to the International Swaps and Derivatives Association, the market grew 33% in the second half of 2006, rising from $26.0 trillion in notional value to $34.5 trillion by the end of the year. Financial firms and hedge funds comprise most of the participants in the market. They find it less expensive and easier to use these contracts to hedge and to speculate rather than to buy and sell the underlying debt.

Prices of credit default swaps fall as the perception of a company's ability to repay its debt improves, and rise when the outlook worsens. Last week, as Bear Stearns (NYSE: BSC  ) struggled with its hedge fund mess, credit swaps on the firm rose to their highest levels since they began trading in 2001. Prices on Tribune (NYSE: TRB  ) credit swaps also jumped, as speculation grew that the company might miss interest payments on the $13 billion of debt it will have following Sam Zell's purchase of the company.

So watch for news items about a company's credit swaps. Even though you're probably not a party to these transactions, you can still profit from keeping up on their price movements. By noting the perceptions of the big players, you'll gain a fuller picture of a company's financial health.

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Fool contributor S.J. Caplan, a former vice president and assistant general counsel of Goldman Sachs and former vice president and derivative finance specialist at Lehman Brothers, does not own shares of the companies discussed in this article. The Fool has a disclosure policy.

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