Credit Default Swap
A Credit Default Swap (CDS) is a financial derivative contract that functions as a form of insurance against the credit risk or default of a borrower, such as a corporation or sovereign entity. In a CDS agreement, the buyer of protection pays a regular premium (the CDS spread) to the seller of protection, typically a financial institution or investor. In return, the seller agrees to compensate the buyer if a defined credit event occurs—such as default, bankruptcy, or restructuring of the underlying debt instrument.
For investors holding bonds or loans, a CDS provides a way to hedge credit exposure, protecting against potential losses if the borrower fails to meet obligations. However, CDS can also be used speculatively by investors who do not own the underlying debt, allowing them to take positions on the perceived creditworthiness of issuers—profiting from widening or tightening credit spreads.
CDS contracts are usually standardized and traded over-the-counter (OTC), though increased post-crisis regulation has encouraged greater transparency and central clearing. They form the building blocks for credit indices such as the iTraxx and CDX, which track baskets of CDS contracts and are widely used for portfolio hedging and credit market exposure.
While CDS play a key role in credit risk management and market liquidity, they also carry counterparty risk, since protection depends on the solvency of the seller, and systemic risk, as seen during the 2008 financial crisis. Despite these concerns, the CDS market remains a cornerstone of global credit trading and risk transfer, offering insight into market sentiment about default probabilities and credit conditions.
