Credit Default Swap

Also known as: CDS

Insurance on a borrower's default — and the market's sharpest real-time gauge of credit fear.

3 min read · 592 words · Updated

1 · SnapshotThe one idea to remember
Key intuition: a CDS separates a bond into its two ingredients — interest-rate risk and default risk — and lets you trade the default part alone.
2 · BeginnerWhat is it, really?

A credit default swap works like an insurance policy on a loan or bond. The protection buyer pays a regular premium; if the referenced company (or country) suffers a credit event — fails to pay, restructures, goes bankrupt — the protection seller compensates them for the loss on the debt.

Two things make CDS more than insurance. First, you don't need to own the bond — you can buy protection as a pure bet that a borrower is in trouble, or sell protection to earn premium as a bet that it isn't. Second, CDS trade constantly, so their price — the spread, in basis points per year — is a live ticker of how worried the market is about any name.

When a company's CDS spread jumps from 100 to 400, the market just repriced its survival odds — often faster and more brutally than its bonds or stock.

Insurance on a company you need not own
Protection buyerpays the premiumProtection sellercarries the riskReference entitythe company itself1A standardised coupon3Par minus the auctionprice2A committee decides ithappened4It owes neither side a thing

a paymentonly if a condition is metnot a payment

Neither party has to hold the debt, and the company being insured is not a party to the contract and need never know it exists.

Every quarter, while nothing happens

  1. Protection buyer → Protection seller Traded at a fixed coupon with an upfront payment squaring the difference against the market spread, so that contracts on the same name are fungible.

If a credit event occurs

  1. Reference entity → Protection buyer Bankruptcy, failure to pay, or in some regions a restructuring. A committee rules on it, and its decision binds every contract on that name.
  2. Protection seller → Protection buyer An auction of the defaulted debt sets one recovery price, and every contract cash settles at it on the same day.

one auction price settles every contract on that name

What is not insured

  1. Reference entity → Protection seller The reference entity is a name in a document. This is why the amount of protection outstanding can exceed the debt it references.
Asset class
Credit derivatives
Instrument type
Default protection swap
Traded
OTC, standardised, largely cleared
Typical users
Banks, credit funds, insurers

Which risks decide the outcome

Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.

  • Marketmatters
  • Creditdecides it
  • Liquiditybarely applies
  • Fundingmatters
  • Operationaldecides it

What decides it here. Credit decides the payoff and documents decide whether it is paid: the wrong reference obligation, a successor after a merger, or a restructuring that counts in one region and not another.

What the five mean, and which one decides where →

3 · IntermediateHow it works in practice

Standardised mechanics (post-2009 "Big Bang")

  • Fixed coupons: contracts pay standardised running coupons (100bp investment grade / 500bp high yield); the difference from the true spread is settled upfront.
  • Credit events: bankruptcy, failure to pay, restructuring (region-dependent) — determined by an ISDA Determinations Committee, not by lawsuits.
  • Settlement: an auction sets the defaulted debt's recovery price; protection pays (100 − recovery)%.
  • Maturity: 5-year is the liquid point; standard roll dates (Mar/Sep 20).

Uses

  • Hedging: a bank hedges loan concentrations it cannot sell.
  • Shorting credit: buying protection is the practical way to short a bond (borrowing bonds is hard).
  • Basis trading: bond spread vs. CDS spread on the same name — the CDS-bond basis converges, mostly.
  • Curve trades: 1y vs 5y protection expresses when trouble hits, not just whether.
Worked example: buy 5y protection on €10M at 200bp — pay €200k/year. The company defaults in year 2; the auction sets recovery at 35%. You receive (100−35)% × €10M = €6.5M. Total premiums paid: ~€400k.
4 · AdvancedPricing & valuation

Pricing: hazard-rate framework

Model default as the first jump of an intensity process \(\lambda_t\); survival \(Q(t) = e^{-\int_0^t \lambda_s ds}\). The par spread equates the premium and protection legs:

$$ s \sum_i \delta_i P(0,t_i) Q(t_i) \;=\; (1-R)\int_0^T P(0,t)\,\big(-dQ(t)\big) $$
What the symbols mean
  • deltaa small change in whatever follows
  • Pa price, or a present value
  • ta point in time
  • Ra return
  • Tmaturity, in years

yielding the credit triangle \(s \approx \lambda (1-R)\) for flat hazards. Quoting runs through the ISDA Standard Model: flat hazard bootstrapped per tenor with fixed recovery assumption (40% senior), converting spreads ↔ upfronts consistently across the street.

Marking a seasoned position

Value = (current spread − contract coupon) × risky annuity (RPV01, the survival-weighted premium PV). Risk metrics: CS01 (P&L per bp of spread), JTD (jump-to-default: (1−R)·N minus mark), and recovery-rate sensitivity — the three axes of a credit book.

Basis and wrong-way subtleties

The CDS-bond basis reflects funding (bonds need balance sheet; CDS doesn't), the cheapest-to-deliver option in the auction, restructuring-clause differences and repo. Persistent negative basis (bonds cheap vs. CDS) rewards buy-bond-buy-protection packages — until funding stress, as in 2008, blows the convergence trade up. Counterparty wrong-way risk (buying bank protection from a correlated bank) drove the move to central clearing.

Sovereign CDS

Reference sovereign debt with restructuring-heavy event definitions; quanto effects matter (EUR-denominated protection on Italy pays in a currency whose value co-moves with the event) — priced via jump-at-default FX models.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.

5 · Desk notesHow practitioners think about it
Practitioner note: the 5y CDS spread is credit's headline number, but the curve (1s5s) and the basis carry the analytical content: inversion says "soon", deep negative basis says "funding stress".

Now say it back

Close the page and give Credit Default Swap in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.

  1. Who wants what — two parties wanted opposite things badly enough to write it down.
  2. What the contract obliges, and when — not the payoff; the obligation.
  3. Where the money comes from — name the source, or you have described a hope.
  4. What makes it lose — the ordinary way, not the dramatic one.

Do it with a clock → · why these four

Put Credit Default Swap beside any other instrument →

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Where this instrument shows up elsewhere

Information and education only. Every page, figure and calculator on this site exists to explain how financial instruments work. Nothing here is investment, tax or legal advice, a recommendation, or a valuation you can rely on. Full disclaimer