Credit Default Swap

A credit default swap (CDS) is a swap contract where one party (the buyer) pays periodic premiums to another party (the seller) to transfer credit risk on a reference entity (corporation or sovereign). If the reference entity defaults on its debt, the seller pays the buyer a large sum (insurance-like payout). CDS are used to hedge bond portfolios, speculate on credit, and price credit risk. They became infamous during the 2008 financial crisis when the notional value of CDS exceeded the world’s GDP.

How a CDS works

An investor holds $10M of XYZ Corporation bonds (maturing in 5 years). Worried about default risk, the investor buys 5-year CDS protection for $10M notional.

CDS terms:

• Premium: 150 basis points (1.5%) per year = $150,000/year
• Seller: Bank or another investor
• Protection: If XYZ defaults, seller pays $10M (or difference between par and recovery value)

Scenario 1 (no default): Investor pays premiums quarterly for 5 years ($150K × 5 = $750K total). XYZ survives; premiums are the “insurance cost.”

Scenario 2 (default): In year 3, XYZ defaults. Bonds recover 40% = $4M. Investor owns $4M value. The CDS seller pays $6M (the difference from par). Net: Investor has full $10M value.

Credit spreads and CDS pricing

The CDS premium (spread) reflects the market’s perception of default risk. A solid investment-grade company might trade at 50 bps; a distressed company at 500+ bps.

As a company’s financial health declines, its CDS spread widens (premiums rise). A CDS spread spike is an early-warning signal of default risk.

Naked CDS: speculation

Not all CDS buyers hold the underlying bond. A speculator can buy CDS on a company with no position, betting on default. If the company defaults, the speculator profits.

This is called a naked CDS and is essentially a credit bet, not a hedge.

CDS index and correlation

A CDS index (e.g., CDX, iTraxx) aggregates CDS on 125+ corporations. Trading the index is a bet on broad credit, allowing managers to hedge portfolio credit risk without individual bond trades.

During crises, correlations spike: all credits fall together, and credit spreads widen across the board. A CDS index provides efficient hedging.

2008 crisis and CDS

CDS played a central role in the 2008 crisis. Banks sold massive amounts of CDS on mortgages (mortgage-backed securities), creating exposure they could not pay when defaults soared. AIG, a major CDS seller, was bailed out for $182 billion.

The notional value of CDS exceeded $60 trillion at peak—a systemic risk. Post-crisis, CDS are increasingly standardized and cleared through central counterparties.

Basis trade

A CDS basis is the difference between a bond’s credit spread and its CDS spread. If the bond spread is 150 bps but the CDS spread is 120 bps, there is a 30 bp basis.

Sophisticated investors exploit basis by going long the bond and long CDS, or short bond and short CDS, hedging market risk while capturing basis value.

See also