Credit Default Swap (CDS)
A financial contract that transfers the credit risk of a bond or loan from one party to another in exchange for periodic premium payments.
What is Credit Default Swap?
A credit default swap (CDS) is a derivative contract in which one party (the protection buyer) pays periodic premiums to another party (the protection seller) in exchange for compensation if a specified borrower (the reference entity) defaults or experiences a credit event such as bankruptcy or debt restructuring. CDS contracts function similarly to insurance on credit risk but are traded instruments that can be bought and sold without owning the underlying debt. CDS spreads — the annual premium expressed in basis points — reflect the market's assessment of default probability. CDS were central to the 2008 financial crisis, as they were used extensively to create leveraged exposure to subprime mortgage risk.
Example
A hedge fund owns $10 million in bonds issued by a corporation and buys a CDS for protection. It pays 200 basis points (2%) per year ($200,000 annually) to a bank. If the corporation defaults, the bank pays the hedge fund $10 million (or the difference between par and recovery value). If no default occurs, the bank keeps all the premium payments.
Source: BIS — Credit Default Swaps