Credit Default SwapCDS
A credit default swap is a contract in which one party pays a regular premium and the other agrees to compensate it if a named borrower suffers a credit event such as default. The annual premium, the CDS spread, is a market gauge of that borrower’s credit risk.
A credit default swap works much like insurance against a borrower failing to pay. One side pays a steady fee; the other side pays out if a defined credit event happens. Investors use CDS to hedge bonds they own, to take a view on a company’s credit, or simply to read how risky the market thinks a borrower is. This entry explains how CDS work, how the spread is quoted and what can go wrong.
- Category
- Bonds and Interest Rates
- Reading time
- 4 min
- Also called
- CDS spread, Credit protection
- Updated
A credit default swap in plain words
The protection buyer pays a fixed periodic fee; the protection seller makes a payment only if a credit event hits the reference borrower.1 The buyer sheds credit risk and the seller takes it on.
The periodic fee is quoted in basis points of the notional amount and is called the CDS spread.2 A higher spread means the market sees more default risk. See Default Risk.
How a CDS works, step by step
Name the reference entity
The company or government whose credit is being protected.
Set notional and term
For example $10 million of protection for five years.
Agree the spread
The buyer pays it periodically until maturity or a credit event.2
Watch for a credit event
The contract defines what counts, such as default.1
Settle if triggered
The seller covers the loss, in effect paying par for a defaulted bond.2
Or let it expire
With no credit event, the buyer’s premiums are the cost of protection.
Worked examples
Example 1 — Paying for protection
Cost of hedgingA fund buys $10,000,000 of five-year protection at a spread of 150 basis points (1.50%) a year, paid quarterly.
| Annual premium | $10,000,000 × 1.50% = $150,000 |
| Per quarter | $150,000 ÷ 4 = $37,500 |
The fund pays a known cost for insurance against default.
Example 2 — A credit event
Protection paidThe borrower defaults and its bonds are valued at 40% of face value.
| Payout to buyer | $10,000,000 × (100% − 40%) = $6,000,000 |
The buyer is compensated for the loss below par; the seller bears it. See Loss Given Default.
Example 3 — Spread widening
Sellers loseBefore any default, worries grow and the spread rises from 150 to 400 basis points.
| New annual cost | $10,000,000 × 4.00% = $400,000 |
Protection becomes more expensive, so existing buyers gain in value and sellers lose, even without a default.
Protection buyer vs. protection seller
| Aspect | Buyer | Seller |
|---|---|---|
| Pays | The periodic spread | A payout after a credit event |
| Credit view | Hedging or negative | Positive |
| Gains when | Spreads widen or default occurs | Spreads tighten and nothing happens |
| Key risk | The seller cannot pay | A sudden default |
Why CDS matter
Hedging bonds
Bondholders can protect against default. See Hedging.
Credit views
Traders can express a view without owning the bond.
Market signal
CDS spreads show credit risk in real time. See Credit Spread.
Bank risk management
Lenders can reduce concentration to a single borrower.
Advantages and disadvantages
Advantages
- Transfers credit risk without selling the bond.
- Quoted spreads give a clear gauge of credit risk.
- Standardised contracts for many borrowers.
Disadvantages
- Counterparty risk if the seller cannot pay. See Counterparty Risk.
- Sellers face large, sudden losses.
- Complex legal definitions of credit events.
- Can be used to speculate rather than hedge.
Going deeper
Read as far as you need. Each level builds on the one before it.
Basis points
Beginner
A basis point is one hundredth of a percentage point, so 150 basis points equals 1.50%.
What spreads tell you
Intermediate
In a Federal Reserve study, CDS spreads rose steadily as credit ratings fell — from 17 basis points for AAA borrowers to 603 for CCC.2
Counterparty and clearing
Advanced
A CDS is only as good as the seller’s ability to pay. Many contracts are now cleared through central counterparties, which reduces but does not remove that risk.
Common mistakes
Treating it as risk-free insurance
The seller can fail too.
Ignoring spread changes
Prices move long before any default.
Assuming any bad news triggers a payout
Only defined credit events count.
Forgetting the premium cost
Protection that never pays out still costs money.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- A CDS transfers credit risk from buyer to seller.
- The buyer pays a periodic spread in basis points.
- The seller pays out after a defined credit event.
- Spreads rise when credit risk rises.
- Counterparty risk matters on both sides.
Frequently asked questions
Is a CDS the same as insurance?
What counts as a credit event?
Can retail traders use CDS?
Further learning
- Default Risk
What a CDS protects against.
- Loss Given Default
How payouts relate to recoveries.
- Counterparty Risk
The risk that the seller fails.
- Credit Spread
Bond spreads and CDS spreads compared.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Bank for International Settlements. BIS Data Portal glossary: credit default swaps (opens in a new tab) Checked .
- Federal Reserve Board. Credit Default Swap Spreads and Variance Risk Premia (FEDS 2011-02) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.