Credit Default Swap
Financial derivative transferring credit risk of a reference entity from protection buyer to protection seller.
A credit default swap (CDS) is an over-the-counter (OTC) financial derivative in which the protection buyer pays periodic premiums (the CDS spread, quoted in basis points per year) to the protection seller in exchange for compensation if a specified credit event—default, bankruptcy, restructuring, or failure to pay—affects the reference entity (a corporation, sovereign government, or structured credit vehicle).
CDS function like insurance against credit risk without requiring ownership of the underlying debt. Investors use CDS to hedge credit exposure in their bond or loan portfolios (buying protection), to speculate on credit deterioration of a company (buying protection without owning the bonds), or to take on credit risk synthetically and earn premium income (selling protection).
The CDS spread reflects the market's perception of default risk—a widening spread signals deteriorating creditworthiness. Investment-grade companies typically trade at 20–100 basis points annually; high-yield companies at 200–800bps+. CDS spreads on sovereign debt (Greece in 2012, Turkey in 2018) explode during debt crises.
The 2008 financial crisis exposed massive systemic risks in the CDS market, particularly unhedged positions at AIG Financial Products, which had sold protection on mortgage-backed securities without adequate capital reserves. Post-crisis, the Dodd-Frank Act required most standardized CDS to be centrally cleared through clearinghouses, reducing counterparty risk.
CDS indices (CDX in North America, iTraxx in Europe) represent baskets of CDS contracts on investment-grade or high-yield credits, allowing portfolio-level credit hedging with a single instrument. These indices are among the most liquid credit instruments globally.
FAQs
How is a credit default swap different from a bond?
A bond is a cash instrument where an investor lends money to an issuer and receives periodic interest and return of principal. A credit default swap is a derivative that transfers credit risk without requiring the transfer of the underlying bond. A CDS buyer obtains the economic benefit of credit protection (compensation if the reference entity defaults) without owning the bond. A CDS seller earns premium income (like coupon income) but faces loss if the reference entity defaults, without having lent money. CDS enable credit risk transfer between parties without the capital required for bond ownership.
What triggers a CDS payout?
CDS payments are triggered by 'credit events' as defined in the ISDA Master Agreement, which governs most CDS contracts. Standard credit events include bankruptcy (filing under applicable insolvency law), failure to pay (missing a principal or interest payment above a minimum threshold after any grace period), and restructuring (adverse changes to debt terms such as interest reduction, maturity extension, or principal haircut). The ISDA Determinations Committee (DC) rules on whether a credit event has occurred when disputed, ensuring consistent interpretation across the market.
Can companies use CDS to hedge their own credit exposure?
Companies typically do not buy CDS on their own credit because it would be economically circular—a company buying protection on itself would receive payment precisely when its own financial distress means it cannot fulfill other obligations. However, companies use CDS on counterparty credit risk: a company with significant accounts receivable from a customer with questionable creditworthiness could buy a CDS on that customer, effectively hedging the risk that the customer defaults on its obligations. Banks use CDS extensively to manage the credit risk concentrations in their lending portfolios without requiring the loans to be sold.
Related Terms
Yield Curve
Graph of interest rates across different maturities for similar credit quality bonds, typically U.S. Treasuries.
LIBOR
London Interbank Offered Rate, the formerly dominant global benchmark for short-term interbank lending, now discontinued.
SOFR
Secured Overnight Financing Rate, the primary U.S. replacement for LIBOR, based on overnight Treasury repo transactions.
BSA (Bank Secrecy Act)
U.S. primary anti-money laundering law requiring financial institutions to assist in detecting and preventing financial crimes.
