202503211709 - Credit Default Swap

overseen by credit Rating Agencies

A credit default swap (CDS) is a financial derivative contract that allows an investor to swap or offset their credit risk with that of another investor.

In a CDS, the buyer makes periodic payments to the seller, and in exchange, the seller agrees to pay a lump sum to the buyer if the underlying credit instrument, such as a bond or loan, defaults or experiences a similar credit event like bankruptcy or restructuring[1][2][3].

How CDS Works

• Parties Involved: The two parties to a CDS are the credit protection buyer and the credit protection seller. The buyer is typically seeking to hedge against the risk of default by a borrower, known as the reference entity[4].
• Payment Structure: The buyer pays an ongoing premium, often referred to as the CDS spread, to the seller until the contract matures. In return, the seller agrees to compensate the buyer if a credit event occurs[1][2].
• Credit Events: These include failure to pay, 202503211603 - Bankruptcy, and restructuring. Upon such an event, the seller pays the buyer the face value of the bond or its market value, depending on the settlement terms[2][4].

Uses of CDS

CDSs are used for both hedging and speculation:

• Hedging: Investors holding debt instruments can purchase CDSs to protect against potential defaults, similar to buying insurance[3][6].
• Speculation: Investors can buy CDSs without holding the underlying debt, essentially betting on the likelihood of default by the reference entity. This practice is known as a "naked" CDS[2][5].

History and Impact

CDSs have been in use since the early 1990s and gained prominence in the early 2000s. They played a significant role in the 2008 financial crisis, as large banks faced substantial losses when numerous underlying credit instruments defaulted simultaneously[1][3]. In response, regulatory measures such as the Dodd-Frank Act were implemented to increase transparency and oversight in the CDS market[3].

Sources
[1] Credit Default Swap: What It Is and How It Works - Investopedia https://www.investopedia.com/terms/c/creditdefaultswap.asp
[2] Credit default swap - Wikipedia https://en.wikipedia.org/wiki/Credit_default_swap
[3] credit default swap | Wex - Cornell Law School https://www.law.cornell.edu/wex/credit_default_swap
[4] Credit Default Swaps | CFA Institute https://www.cfainstitute.org/insights/professional-learning/refresher-readings/2025/credit-default-swaps
[5] Credit Default Swap - Defintion, How it Works, Risk https://corporatefinanceinstitute.com/resources/derivatives/credit-default-swap-cds/
[6] What are Credit Default Swaps? - YouTube https://www.youtube.com/watch?v=iKLoJtz81n8
[7] What is "Credit Default Swap"? : r/investing - Reddit https://www.reddit.com/r/investing/comments/xuy5eg/what_is_credit_default_swap/
[8] What Is a Credit Default Swap (CDS)? - GoCardless https://gocardless.com/en-us/guides/posts/credit-default-swap/