A Credit Default Swap (CDS) is a financial derivative or contract that allows an investor to “swap” or offset their credit risk with that of another investor.
Here’s how it works:
- Party A believes that Party B will default on its debt, so Party A buys a CDS from Party C (usually an insurance company, bank, or other financial institution).
- Party C promises to insure Party A against a default by Party B. In return, Party A pays a premium to Party C, usually on an ongoing basis.
- If Party B defaults, Party C has to purchase the defaulted debt for its face value or cover the loss suffered by Party A.
- If Party B doesn’t default, Party C keeps the premium and makes a profit.
So, in simpler terms, a Credit Default Swap is like insurance against a bond default. The buyer of the CDS pays a premium in exchange for safety: if the bond defaults, the buyer won’t lose money because the CDS seller will compensate them.
One important thing to note is that the buyer of a CDS does not need to own the underlying security; they can use it purely as a speculative device. This characteristic was a key factor in the financial crisis of 2008, as it allowed for a buildup of risk in the financial system.