Credit default swap (CDS)

This page explains credit default swaps. CDS is also an abbreviation of central depositary system.

A credit default swap (CDS) is a derivative that serves as a way of transferring some of the risk in a debt instrument. It transfers only the risk of default, in return for payment, making it more akin, in its economic effect, to insurance, than to other types of swaps.

The seller of a credit default swap is in a similar position to the writer of an option. If there is no default on the underlying, then the seller makes money. If there is a default the seller has to cover it.

Similarly, the buyer of a CDS is in a similar position to the buyer of a put option. Buying a CDS hedges the default risk. Like an option, a CDS may be bought to gain geared exposure to speculate on movements in the underlying.

Buying a credit default swap does not eliminate all the risks associated with holding debt: interest rate risk, in particular, remains with the holder. Given the type of risk being transferred, payment to the seller should reflect the risk premium (i.e. the spread).