A credit default swap (CDS) is a mechanism for spreading the default risk of securities and loans enabling lenders and investors to manage their risk profiles and better achieve financial goals
In its purest form, a CDS is simply an insurance contract. The buyer of protection (or buyer of insurance) makes periodic payments (akin to regular insurance premiums) to the seller (or insurer) expressed as a number of basis points per annum (see figure below). The seller makes payments to the protection buyer if a credit event occurs.
A credit event is predetermined between the parties and could be a payment default, bankruptcy or debt rearrangement. If such an event occurs then the protection seller will make a payment to the protection buyer and the swap will terminate.
Typically, CDS pay the buyer face value if a credit event has occurred in exchange for the underlying securities or the cash equivalent. Contracts are expressed in terms of basis points; a basis point is 0.01 percentage point and equals $1,000 annually on a contract protecting $10 million of debt for five years. A decrease in basis points indicates improvement in the perception of credit quality; an increase, the opposite.
The price of the derivative depends on the credit quality of the reference entity as well as the supply and demand of the swaps in the market and current market spreads.
Essentially CDS are a proxy for credit risk and are used to derive relative value assessments and trends in credit quality. As highly traded and liquid instruments they are also very responsive to market news and are an excellent way of gauging market reactions.
Originally they were meant as a type of insurance to offset risk but have developed into an investment vehicle to the point where CDS now outweigh the cash value of the bonds on issue.
In an efficient market CDS would be similar to the spread of a bond.
CDS are a type of derivative, that is their characteristics and pricing are derived from another underlying instrument.
CDS are the domain of banks and funds. Individuals are generally not able to trade in CDS.