Lesson 64 - Advanced Accounting Course

Lesson 64: Credit Default Swaps (CDS): Risk and Accounting Treatment

💡 What Is a Credit Default Swap (CDS)?

A Credit Default Swap (CDS) is a type of financial contract that acts like insurance against the default of a borrower (like a company or government).

🎯 In short: If someone you lend money to can't pay, a CDS can protect you.

👥 Who’s Involved?

🔁 How It Works

Imagine Company A holds bonds from Company X worth $10 million.
Company A is worried Company X might default. So:

1. Company A buys a CDS from Bank B.
   
   

2. Company A pays Bank B an annual fee (called the CDS spread).
   
   

3. If Company X does not default — nothing happens.
   
   

4. If Company X defaults, Bank B pays Company A the loss amount.
   
   

🎉 Just like car insurance… but for debt!

📊 CDS: Real-World Example

If Company X defaults, the protection seller pays the loss, e.g., $4 million if recovery value is only $6 million.

🧠 Why Use a CDS?

📉 Risks of CDS 

🧾 Accounting Treatment for CDS (IFRS & US GAAP)

📘 Under IFRS 9 and ASC 815:

🧾 If Part of a Hedge:

• Must meet strict hedge accounting rules
  
  

• Requires hedge documentation, effectiveness testing, and ongoing monitoring

📚 Summary Table

💡 Did You Know?

🧠 You can buy a CDS even if you don’t own the bond – it's called a naked CDS.
✅ Legal but controversial — it can be used to bet on companies failing!

✅ Key Takeaways

• 💥 CDS help manage credit risk in bonds and loans
  
  

• 📈 They're widely used by banks, investors, and insurers
  
  

• 🧾 Accounting rules require fair value reporting and disclosures
  
  

• ⚠️ Improper use can increase financial instability and ethical concerns