Credit Default Swap (CDS)
A credit default swap is a contract in which the protection buyer pays a regular premium to the protection seller, who pays out if a named borrower suffers a defined credit event such as default. It moves credit risk without moving the underlying loan or bond.
Also called: CDS · credit default swaps · credit protection · single-name CDS
The buyer pays a premium, quoted as a spread in basis points a year on the notional amount protected. If the reference entity suffers a credit event defined in the contract, such as failure to pay or bankruptcy, the seller compensates the buyer for the loss, normally the notional less the recovery value of the debt. If no event occurs, the seller keeps the premiums.
A buyer does not need to own the debt. Holding protection without the bond is a bet that the borrower's credit will worsen, and the spread at which protection trades has become a market price for a borrower's credit risk. Standardised index CDS can now be cleared through a central counterparty.
The danger sits with the seller. The Financial Crisis Inquiry Commission found that AIG sold protection on mortgage-related securities without having been required to put aside capital reserves for it, and that the US government had to step in when it could not meet its obligations. AIG did not run out of money because defaults arrived; it ran out because downgrades and falling values triggered collateral calls long before most losses were realised. For any firm, protection is only as good as the seller's ability to pay when the event it covers is also stressing everyone else.
In practice
A CDS pays only on the credit events its terms define. Restructurings, technical defaults and disputes over what counts as an event have all produced outcomes that protection buyers did not expect.
Example
An investor buys five-year protection on US$10 million of a company's debt at 150 basis points, paying US$150,000 a year. Two years later the company defaults and its bonds recover 40 cents on the dollar. The seller pays US$6 million, the notional less the recovery value.
Learn more on Money Wiki
This page gives the short answer. Money Wiki has a longer guide to Credit Default Swap, with more detail and background.
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Commonly confused with
| Term | How it differs |
|---|---|
| Credit insurance | Insurance pays only a policyholder who has suffered the loss. A CDS buyer need not own the debt at all, and the contract is a derivative, not an insurance policy. |
See also
- DerivativeA derivative is a contract whose value comes from the price, rate or event it references, called the underlying. It lets parties take on or shed exposure to that underlying without buying or selling the underlying itself.
- Margin CallA margin call is a demand that a party to a leveraged position or derivative post more collateral, usually cash, because the position has moved against it or the required margin has risen. If the call is not met, the counterparty can close the position.
- Notional AmountThe notional amount is the reference size of a derivative contract, the face value on which its payments are calculated. In many derivatives it is never exchanged, and it is not the amount at risk, which is usually a small fraction of it.
- Central CounterpartyA central counterparty is a clearing house that steps between the two sides of a trade, becoming the buyer to every seller and the seller to every buyer, so that each party's exposure is to the CCP rather than to the other.
- Basis PointA basis point is one hundredth of one percentage point — 0.01%. FX and payments pricing is quoted in basis points because small percentages are easy to misread: 25 basis points is 0.25%, and 100 basis points is 1.00%.