Credit Default Swaps Explainer
A credit default swap, or CDS, is a contract in which a protection buyer makes periodic payments to a protection seller. If a defined credit event affects the reference entity or obligation, the seller owes the contractually specified protection payment.
The reference entity, notional amount, maturity, eligible obligations, credit-event definitions, and settlement method are central terms. Settlement may involve delivering eligible debt for par value or using a cash amount determined from a standardized auction or other procedure.
CDS spreads reflect the market price of protection and respond to perceived default risk, recovery expectations, liquidity, funding, and supply and demand. A wider spread often signals more expensive protection, but it is not a simple or certain default probability.
Bondholders can use CDS to hedge, while other participants may take credit exposure without owning the debt. The hedge can diverge because of contract basis, maturity, restructuring terms, cheapest-to-deliver options, and counterparty risk. Clearing and collateral reduce some exposures but add margin needs.
The seller owes a payment only after a contractually covered credit event.
Terms determine what counts and how settlement works.
Entity, obligation, maturity, and deliverables must be identified.
A broad company view is not enough.
Basis, recovery, liquidity, and contract terms can diverge from the owned debt.
Counterparty and margin risk remain.
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