Credit default swap (CDS).
In plain English
A credit default swap works like insurance on a bond: the buyer pays a periodic fee and the seller agrees to cover the loss if the named borrower fails to pay. Payment is triggered by a defined credit event, such as missed payments or a restructuring, judged under standard market documentation rather than by either party alone. Unlike insurance, a buyer does not need to own the underlying bond, so the market can be larger than the debt it references. Prices are quoted as an annual spread, and a rising spread signals that the market sees more default risk. Sellers collect steady premium and take a large, rare loss, which is why concentrated positions can be dangerous.
01Why it matters
CDS pricing is a live read on how likely the market thinks a company or a government is to default, visible even when the underlying bonds trade rarely.
02The math, step by step
Protection on 10 million of a company's debt is quoted at 200 basis points, so the buyer pays 2 percent a year, or 200,000. If the company defaults and recovery on the bonds is 40 cents on the dollar, the seller owes the 60 percent shortfall, or 6 million.
Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.
03What this is NOT
A credit default swap is not an insurance policy. Insurance requires an insurable interest and a regulated insurer holding reserves. A CDS can be bought by someone with no exposure to the borrower at all, and the seller posts collateral by contract rather than by insurance law.
04Receipts
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Plain-English answers from our glossary. Receipts included. Never advice.
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