LOS b: Explain the advantages of using credit derivatives over other credit instruments.

Credit default swaps are not highly regulated because they are confidential, over-the-counter contracts. Liquidity is often greater in the credit derivative market than it is in the underlying cash market.

If an investor believes the firm’s credit prospects are good and wishes to discreetly capitalize on this by taking a long position, the investor should sell a credit default swap. Credit derivatives are confidential, over-the-counter contracts. By selling the swap, the investor would receive a premium up front and owe no further compensation to the swap buyer if in fact the debt does not experience credit risk.

If an investor believes the firm’s credit prospects are poor in the near term and wishes to capitalize on this, the investor should buy a credit default swap. Although a short sale of a bond could accomplish the same objective, liquidity is often greater in the swap market than it is in the underlying cash market. The investor could pick a swap with a maturity similar to the expected time horizon of the credit risk. By buying the swap, the investor would receive compensation if the bond experiences an increase in credit risk.