Credit Default Swap
A credit default swap (CDS) is a bilateral over-the-counter derivative contract in which the protection buyer pays periodic premiums (the CDS spread) to the protection seller in exchange for a contingent payment if a specified reference entity experiences a credit event — such as default, restructuring, or bankruptcy.
Key takeaways
- The CDS spread (quoted in basis points per annum) is the annual premium paid by the protection buyer on the notional amount; a 200 bps spread on $10M notional = $200,000/year in premium payments.
- A credit event — defined under ISDA documentation — triggers settlement: either physical delivery (buyer delivers defaulted bonds and receives par) or cash settlement (buyer receives par minus recovery rate).
- CDS can be used for hedging (an investor long credit risk buys protection to reduce default exposure) or speculation (selling protection to earn premium income when expecting spread tightening or no default).
- CDS spreads are a real-time market-implied measure of default probability: CDS Spread ≈ Probability of Default × (1 - Recovery Rate), making them a key credit risk gauge for analysts and portfolio managers.
- The 'Big Bang' and 'Small Bang' ISDA protocol changes (2009) standardized CDS contracts and introduced centralized clearing through entities like ICE Clear Credit, significantly reducing counterparty risk in the market.
Explanation
Credit default swaps are the fundamental building blocks of the credit derivatives market, enabling the separation and transfer of credit risk from other financial risks. In a standard ('vanilla') single-name CDS, the protection buyer pays a periodic premium (the CDS spread, s, multiplied by the notional N) typically on a quarterly basis. If no credit event occurs over the contract's term (typically 1, 3, 5, 7, or 10 years), the seller retains the premium income. If a credit event does occur, the contract terminates and the seller makes a contingent payment.
Settlement can occur via two mechanisms. Physical settlement requires the protection buyer to deliver a qualifying deliverable obligation (bonds or loans of the reference entity) with face value equal to the notional amount; the seller pays par (N). In practice, cash settlement using a credit event auction has become dominant since ISDA's 2009 'Big Bang' protocol: a centralized auction determines the final price (recovery value R) of the reference entity's obligations, and the seller pays N × (1 - R) to the buyer. If a $10 million notional CDS settles with a recovery of 40 cents on the dollar, the seller pays $6 million.
The CDS spread reflects the market's assessment of default risk. In a simplified model assuming continuous premiums and a constant hazard rate λ (intensity of default), the CDS spread approximately equals s ≈ λ × (1 - R) = PD × LGD, where PD is the risk-neutral probability of default per annum and LGD = 1 - R is the loss given default. This relationship allows investors to extract implied default probabilities from observable CDS spreads: if a 5-year CDS trades at 300 bps and recovery is assumed to be 40%, then λ ≈ 300 / (1 - 0.40) = 500 bps = 5% annualized default probability.
CDS serve multiple functions in financial markets. Bondholders use them as credit hedges, paying away spread to remove default risk while retaining the yield (the net position — long bond plus CDS protection — creates a synthetic risk-free asset, a basis trade with P&L depending on the CDS-bond basis). Hedge funds speculate by selling protection (receiving premium income) on credits they believe are overcrowded with negative sentiment, or by buying protection on deteriorating credits before spreads widen. Banks use CDS to actively manage regulatory capital by reducing credit risk concentrations. CDO and CLO managers use CDS to gain synthetic credit exposure and optimize portfolio construction. Index products (CDX in North America, iTraxx in Europe) allow efficient macro credit hedging and expression of broad credit cycle views.
Formula
CDS Spread ≈ PD × (1 - Recovery Rate); Cash Settlement = Notional × (1 - Recovery Rate); Implied PD = CDS Spread / (1 - R)
Example
An asset manager owns $10 million face value of a BBB-rated European telecommunications company's 5-year bonds yielding 5.2% (approximately T+200 bps). Concerned about potential credit deterioration, the manager buys $10 million notional 5-year CDS protection on the same entity, paying a spread of 180 bps per annum = $180,000/year. The net carry on the hedged position is approximately 20 bps (bond spread minus CDS cost), but the manager has effectively eliminated default risk. Six months later, the telecom company issues a profit warning and its CDS spread widens to 320 bps. The protection buyer can now close out the CDS position at a gain: the market value of the protection they own has risen substantially (the present value of receiving 320 bps annually on $10M vs. paying 180 bps is positive), partially offsetting the mark-to-market loss on the physical bonds.
Related terms
Basis Binomial Tree Model Bond Cap Cash Settlement Credit Risk Default Delivery Exchange Face Value Floor Hedging