What Is a Credit Default Swap? A Plain-English Guide

A credit default swap (CDS) is a bilateral derivative contract providing insurance against the default of a specified entity — the 'Reference Entity'. The buyer of protection pays a periodic premium to the seller; the seller pays a defined amount if the Reference Entity suffers a 'Credit Event' (typically default). No physical bond needs to be held: CDS are purely contractual.

The basic mechanics

The premium paid by the protection buyer is expressed as an annual percentage of the notional amount — the 'CDS spread'. If a company's CDS trades at 150 basis points, the buyer of £10 million of protection pays £150,000 per year (150bps × £10m) in quarterly instalments for the life of the contract, typically five years.

If no Credit Event occurs, the protection buyer has paid the premium and received nothing in return — like an insurance premium where no claim was made. If a Credit Event does occur, the protection seller pays (1 − Recovery Rate) × Notional: the loss after recoveries.

Credit Events

Under ISDA definitions, Credit Events typically include: bankruptcy, failure to pay (missing a bond or loan payment), and restructuring (changing terms in a way detrimental to creditors). For sovereign CDS, additional Credit Events apply including repudiation and moratorium. Whether a Credit Event has occurred is determined by the ISDA Determinations Committee — a body of major dealers and buy-side firms.

Who uses CDS and why

Bond investors use CDS to hedge credit risk without selling bonds — particularly useful when bonds are illiquid or sales would crystallise a taxable gain. Banks use CDS to manage their loan and bond book exposures. Hedge funds use CDS to express views on corporate creditworthiness — buying protection when they expect deterioration, selling when they expect improvement.

The precise settlement mechanics after a Credit Event, how CDS spreads relate to bond yields, and how banks manage the risk of a large CDS book are explored in Market Mechanics — the complete plain-English guide to how a bank's markets business works.