Credit Default Swap [CDS]

A Credit Default Swap (CDS) is a derivative contract where the protection buyer pays periodic premiums to the protection seller in exchange for compensation if a reference entity (corporation or sovereign) experiences a credit event (default, bankruptcy, restructuring). For example, buying 5-year CDS protection on $10 million of Ford bonds at 200 basis points costs $200,000 annually. If Ford defaults, the protection seller pays $10 million minus recovery value. CDS allows hedging credit risk without selling bonds or speculating on credit without owning bonds. The CDS market grew from near zero in 2000 to over $60 trillion notional by 2007, amplifying the financial crisis when AIG couldn’t honor CDS obligations on mortgage securities. Post-crisis reforms require central clearing for standardized CDS and margin requirements. CDS spreads serve as real-time credit risk indicators – widening spreads signal deteriorating credit. Basis trading arbitrages differences between CDS spreads and bond yields. Critics argue CDS enables speculation and empty creditor problems, while supporters value risk management and price discovery benefits.