A credit default swap is a derivative contract where the buyer pays a periodic premium to a seller in exchange for protection against a bond issuer defaulting. If the issuer defaults, the seller compensates the buyer for the loss — functioning like insurance on credit risk.
Why It Matters
CDS spreads are one of the market's fastest-moving, most liquid signals of perceived credit risk — often moving before bond prices or rating agency actions catch up, which is why credit desks watch them as an early-warning system. CDS also let investors take a view on credit risk (long or short) without owning the underlying bond, and let bondholders hedge exposure without selling the position.
How It Works in Practice
- 1The protection buyer pays a periodic spread (quoted in basis points) to the protection seller
- 2If a defined 'credit event' occurs (default, bankruptcy, or restructuring), the contract is settled — physically (bond delivered for par) or via cash (based on the bond's post-default market value)
- 3The CDS spread itself is a market-implied estimate of default probability and expected recovery
- 4Single-name CDS reference one issuer; CDS indices (like CDX and iTraxx) reference baskets of issuers and are more liquid
Common Pitfalls
CDS create counterparty risk of their own — the protection is only as good as the seller's ability to pay, a lesson from the 2008 crisis (AIG)
Basis risk exists between the CDS and the actual bond it references — they don't always move in lockstep
Determining whether a 'credit event' has technically occurred (especially for restructurings) can be contentious and is decided by an industry determinations committee, not automatically