What are credit default swaps?

A credit default swap (CDS) is a derivative contract in which the buyer makes periodic premium payments to the seller in exchange for a payment if a specified "credit event" occurs, such as a bond default, bankruptcy, or debt restructuring. Functionally, a CDS operates like insurance on a bond: the buyer transfers credit risk to the seller for a price, expressed as an annual spread in basis points.

If a company's 5-year CDS trades at 200 basis points, the buyer pays 2% of the notional amount per year to insure against default. If the company defaults, the seller pays the buyer the difference between par and the recovery value of the defaulted bonds. A CDS spread of 200 basis points roughly implies that the market prices a cumulative probability of default around 10-15% over the contract's life, depending on assumed recovery rates.

CDS spreads provide a real-time, market-priced measure of credit risk that is often faster and more responsive than bond spreads. Because CDS are standardized contracts traded among dealers, they can react to news within minutes, while bond prices may lag due to lower liquidity in physical corporate bond markets. Sovereign CDS spreads (on government debt) became particularly important during the European debt crisis of 2010-2012, when Greek, Italian, and Spanish CDS spreads signaled the severity of the fiscal crisis before bond markets fully adjusted.

The CDS market was at the center of the 2008 financial crisis because AIG had sold massive amounts of CDS protection on mortgage-backed securities without adequate capital to pay claims. When the housing market collapsed, AIG's CDS liabilities threatened to trigger cascading counterparty failures across the global financial system, leading to the $182 billion government bailout. Post-crisis reforms moved most CDS trading to central clearinghouses and increased margin requirements, reducing systemic risk. For credit analysts, single-name CDS spreads remain the purest gauge of market-priced default probability, while CDS index products (CDX, iTraxx) provide broad measures of credit market stress.