What Is a Credit Default Swap?
A credit default swap is a contract between two parties referencing the debt of a third party, such as a corporation or a government. The protection buyer makes periodic payments to the protection seller, and if the reference entity suffers a credit event like bankruptcy or failure to pay, the seller compensates the buyer for the loss on the debt.
Crucially, you do not need to own the underlying bonds to trade CDS, which makes it both a hedging tool and a way to take a pure view on credit quality. Buying protection is effectively shorting a company's credit, while selling protection is similar to owning its bonds.
How Spreads Are Quoted
CDS pricing is quoted as an annual spread in basis points on the notional amount protected, where 100 basis points equals 1 percent. A 5-year CDS spread of 150 basis points means protecting 10 million dollars of debt costs 1.5 percent of 10 million dollars, or 150,000 dollars per year, usually paid quarterly.
Wider spreads signal higher perceived default risk: a stable investment-grade company might trade at 50 basis points, while a distressed borrower can trade at 1,000 basis points or more. When spreads get extreme, contracts often trade with large upfront payments plus a fixed running coupon.
Example
Suppose a fund owns 10 million dollars of a company's bonds and buys 5-year CDS protection at 200 basis points, paying 200,000 dollars per year. If the company stays healthy, the fund simply loses the premium, like an insurance policy that never paid out.
If the company defaults and its bonds are worth 40 cents on the dollar afterward, the recovery rate is 40 percent and the protection seller pays the fund the 60 percent loss, or 6 million dollars. The fund's bond loss is offset, which is exactly what the hedge was for.
Why It Matters
CDS spreads are one of the fastest-moving indicators of credit stress, often reacting before bond prices or rating agencies, so traders and risk managers watch them constantly. The product became infamous in the 2008 financial crisis, when sellers of protection on mortgage securities faced losses far beyond their capital, reshaping how derivatives are regulated and cleared.
On credit trading desks and in hedge funds, CDS is a daily tool for hedging, relative value trades between bonds and CDS, and expressing negative credit views that are hard to implement by shorting bonds directly.
