Glossary
Credit Default Swap (CDS)
A contract in which one party pays a regular fee to another for protection against a borrower defaulting on its debt.
A credit default swap is a Derivative that works much like insurance on a borrower's debt. The protection buyer pays the seller a fixed annual fee, quoted in basis points of the amount covered. If the borrower, called the reference entity, suffers a defined credit event such as a missed payment or bankruptcy, the seller pays the buyer for the loss.
How it works
Unlike insurance, a CDS buyer does not need to own the underlying bonds. Many trades are made to bet on or hedge changes in credit quality, and the contract can be sold before a default if spreads move.
What CDS spreads tell you
The price of protection is a live read on how markets view a borrower's Credit Risk. A widening spread means default is seen as more likely or recovery lower; a narrowing one means the reverse. Analysts watch CDS on banks, large companies and governments the way equity investors watch a stock price.
Risks and history
The seller carries the full loss if a credit event occurs, so the buyer also takes on counterparty risk: the protection is only as good as the seller's ability to pay. That weakness came to the fore in 2008, when AIG had sold protection on mortgage-related securities it could not cover and needed a government rescue. Since the Dodd-Frank Act, many standardized index CDS contracts must be cleared through central counterparties, which reduces that risk.