Credit default swaps: insurance against a default

A credit default swap, or CDS, is often described as insurance against a borrower failing to pay. This guide explains what a CDS is, how it works and why its price is watched as a gauge of credit risk.

Quick answer

A credit default swap, or CDS, is a contract that works like insurance against a borrower defaulting on its debt. The buyer pays regular fees, and if the borrower defaults, the seller compensates the buyer. Because the cost of a CDS rises when a borrower looks riskier, it is watched as a market signal of credit risk.

Key takeaways

• A credit default swap works like insurance against default.
• The buyer pays fees to the seller for protection.
• If the borrower defaults, the seller compensates the buyer.
• The cost of a CDS rises when a borrower looks riskier.
• It is watched as a market signal of credit risk.

What is a credit default swap?

A credit default swap is a contract linked to the debt of a borrower, such as a company or a government. The buyer of the swap is seeking protection in case that borrower fails to pay, which is called a default.

It is often compared to an insurance policy. The buyer pays regular amounts, and in return the seller promises to compensate the buyer if the borrower defaults on the debt being covered.

How does it work?

The buyer of the CDS makes ongoing payments to the seller, a bit like an insurance premium. If nothing goes wrong, the seller simply keeps these payments and the contract runs its course.

If the borrower defaults, the seller must pay out to the buyer under the terms of the contract. This is how the CDS transfers the risk of default from the buyer to the seller.

Why is the price of a CDS watched?

The cost of buying protection through a CDS moves with how risky the market thinks the borrower is. If a borrower starts to look shaky, more people want protection, and the cost of the CDS rises.

Because of this, CDS prices are treated as a live gauge of credit risk. A sharp rise in the cost of protecting a company's or country's debt is often read as a warning sign.

How is a CDS different from an interest rate swap?

An interest rate swap exchanges fixed and floating interest payments to manage the risk of changing rates. A credit default swap instead covers the risk that a borrower defaults, which is a different kind of risk entirely.

So while both are called swaps, they address different problems. One is about the level of interest rates, the other is about whether a borrower will repay at all.

Why should everyday investors know about them?

Everyday investors rarely use a CDS, since it is a professional instrument. But CDS prices appear in news as a signal of stress in a company or a country's finances, so they are useful to understand.

Reading CDS moves alongside other signals helps you gauge market worries about credit. Any investment decision should be your own after proper research and reading all related documents.

Frequently Asked Questions