By the FinLingo Team | Capital markets practitioner, front office experience at a major European investment bank. FinLingo covers 342 lessons from bonds to exotic derivatives. About · Last updated:
A credit default swap (CDS) is a derivative that transfers credit risk from one party to another. One side pays a periodic premium; the other side pays a large one-off amount if the reference entity defaults. Structurally, a CDS is insurance — but traded in wholesale markets without an insurable-interest requirement.
A CDS has two legs, just like a standard swap. The premium leg (also called the fee leg) runs from the protection buyer to the protection seller. Payments are typically quarterly, calculated as a fixed coupon × notional × day-count fraction. The coupon is quoted in basis points per year and depends on the reference entity’s perceived credit risk.
The protection leg (contingent leg) runs from seller to buyer and pays off only if a predefined credit event occurs during the life of the contract. Credit events typically include bankruptcy, failure to pay, and (for some contracts) restructuring. On the credit event, the seller pays the buyer (1 − recovery rate) × notional in cash, or delivers a defaulted bond against par, depending on the settlement convention.
The CDS spread is the coupon a fair-value contract would pay. A 5-year CDS spread of 200 bp on a corporate name means protection on that name costs 2% per year. Under a simple mathematical approximation, the CDS spread equals the credit loss expected per year — that is, the annual probability of default multiplied by one minus the recovery rate.
So a 200 bp spread at an assumed 40% recovery implies an annual default probability of roughly 3.3% — a meaningful but not extreme credit. A 1,000 bp spread (10% annual) implies the market expects default with very high probability; these names are typically in distress.
CDS spreads move with credit views just as stock prices move with equity views. A widening spread means credit is deteriorating; a tightening spread means credit is improving. Watching the CDS curve is the single cleanest way to read the market’s credit view on a name.
Hedgers: a bank that has lent €100m to a corporate can buy CDS protection to transfer the default risk. The loan stays on the balance sheet, but the economic exposure is shifted to the protection seller.
Investors expressing views: hedge funds and asset managers buy protection when they think credit will deteriorate (betting on wider spreads) and sell protection when they think credit is improving (earning the premium). Selling CDS is economically similar to lending — you earn income, you bear default risk.
Arbitrageurs: trade the basis between CDS spreads and cash bond yields. If a bond yields significantly more than the matching CDS spread would imply, the basis is “positive” and arbitrageurs can buy the bond and buy protection for an apparently risk-free spread. The basis trade famously blew up during 2008 when funding costs spiked.
CDS was at the centre of the 2008 crisis not because the product is inherently dangerous but because of concentration and complexity. AIG Financial Products had sold roughly $450 billion of CDS protection on mortgage-backed assets. When those assets defaulted or downgraded, AIG owed collateral calls it could not meet — leading to the US government rescue.
The post-crisis reform pushed most CDS trading to central clearing houses and standardised contracts. Most single-name and index CDS now clear through LCH or ICE, which dramatically reduces counterparty risk. The derivative that once defined opaque over-the-counter risk is now one of the most transparent credit instruments.
Economically similar but legally different. Insurance requires insurable interest: you cannot insure your neighbour's house. A CDS does not — you can buy protection on a name you have no direct exposure to. This is the "naked CDS" that regulators debated heavily after 2008.
The pre-defined trigger that activates the protection leg. The three main ISDA-defined credit events are bankruptcy, failure to pay (a missed payment on any of the reference entity's obligations), and restructuring (a material change to debt terms that disadvantages creditors). Exact definitions and triggers are specified in the contract.
Because the market views the reference entity's credit as deteriorating. The probability of default (implied by the spread) rises, so protection becomes more expensive. Spreads also widen during broad credit stress even if the reference name's fundamentals are unchanged — the "credit risk premium" repricing.
FinLingo covers credit derivatives in Level 5 with real-world examples including the 2008 case studies. Level 1 is free.
Start Free