Differences Between Interest Rate Swaps & Credit Default Swaps
Interest rate swaps and credit default swaps are both types of financial derivatives. A financial derivative is a contract between two or more parties in which the parties agree to pay each other a certain sum of money based on the value of an asset, such as a stock, bond or other security. Which party is required to pay money to the other, and how much money he is required to pay, depends on how the value of the asset changes over time.
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Interest Rate Swaps
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In the most basic form of interest rate swap, one party agrees to pay another party regular payments generated from the interest payments on a bond or other interest-generating asset. In return, the other party agrees to make the original party regular fixed cash payments or payments generated from another interest-bearing asset. The payments are generally on the same date as the interest payments. Depending on the present interest rate of the assets -- which changes constantly -- the first party may be required to pay more money than the second party, or vice versa.
Credit Default Swaps
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In a basic credit default swap, one party agrees to make a series of regular cash payments to a second party. In exchange, the second party agrees to pay the first party a certain sum of money if the value of a designated interest-bearing asset, such as a bond, drops steeply. For example, if the issuer of a bond defaults, an individual who has purchased a credit default swap linked to this bond will receive payment from the party from whom he bought the swap.
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Function
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Both interest rate swaps and credit default swaps are designed as a form of protection against changes in the value of an asset; essentially, they are forms of financial insurance. With an interest rate swap, a party, usually a lender or borrower, is hedging against a sudden movement in the interest rate, one that could cost him a large amount of money. With a credit default swap, the party that buys the swap is purchasing compensation in the event that the issuer of an interest-generating asset -- often one that he owns -- defaults.
Further Differences
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Interest rate swaps are generally pegged to the movements of two interest rates. Depending on changes in these rates, one party may be required to pay the second, and then, if the interest rates change, the second party may be required to pay the first. By contrast, credit default swaps are generally pegged to the value of a single asset.
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