Risks in Credit Default Swaps

There are four types of risk in trading credit default swaps:  operational, counterparty, liquidity and pricing.  Operational risk occurs when traders use swaps to mislead investors about their balance sheet i.e. assets versus liabilities.  A counterparty may default on its payments.  Buyers of CDSs may not pay the monthly premiums.  Sellers may be unable to pay the notional amount in case of a default of the reference entity or the sellers themselves may declare bankruptcy and not have to pay the notional amount.   CDSs are traded as bespoke contracts between two counterparties.  If an investor wishes to exit the position, finding another investor to take over the contact, known as novation, may be difficult.  Pricing may be inaccurate as it may be based on the wrong mathematical models.