Credit Default Swap (CDS)
Quick Definition
A derivative contract where one party pays periodic premiums to another in exchange for protection against a credit event like default on a bond or loan.
What Is Credit Default Swap (CDS)?
A credit default swap (CDS) is a financial derivative that functions like insurance against a borrower defaulting on debt. The protection buyer makes periodic premium payments (the "spread") to the protection seller. If a credit event occurs — such as default, bankruptcy, or restructuring — the seller compensates the buyer for the loss. CDS spreads are widely used as a measure of credit risk; wider spreads indicate higher perceived default probability. The CDS market played a notorious role in the 2008 financial crisis, when massive CDS exposure at firms like AIG nearly collapsed the global financial system. Today, the CDS market is more regulated with central clearing requirements. CDS can be used for hedging credit exposure, speculating on credit quality changes, or constructing synthetic credit positions.
Credit Default Swap (CDS) Example
- 1A bank buys CDS protection on $10M of corporate bonds, paying 200 basis points annually ($200,000/year). If the company defaults, the CDS seller pays the bank up to $10M
- 2When a company's CDS spread widens from 100bps to 500bps, it signals the market sees significantly higher default risk — bond prices typically fall simultaneously
Related Terms
Swap
A derivative contract in which two parties exchange cash flows or financial instruments over a specified period.
Notional Value
The total value of a derivatives position based on the underlying asset's price, representing the full exposure rather than the capital invested.
Forward Contract
A customized private agreement between two parties to buy or sell an asset at a specified price on a future date, traded over-the-counter.
Options Premium
The price paid by the option buyer to the seller for the rights conveyed by the contract, determined by intrinsic value, time value, and volatility.
Call Option
A contract giving the holder the right, but not the obligation, to buy an underlying asset at a specified price within a specified time period.
Put Option
A contract giving the holder the right, but not the obligation, to sell an underlying asset at a specified price within a specified time period.
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