Definition
Credit Default Swap (CDS)
A credit default swap is a derivative that pays out if a borrower defaults, functioning like insurance on a bond and whose price reflects the market's view of default risk.
A bond holder can buy a CDS and pay a periodic premium; if the issuer defaults, the CDS seller compensates the buyer. The premium, quoted in basis points, is a real-time market gauge of credit risk.
Sovereign CDS spreads, such as those on India, the US or distressed economies, signal how risky markets judge a government's debt. Widening CDS spreads warned of trouble before the 2008 crisis and the eurozone debt crisis. CDS can also be used to speculate on deteriorating credit without owning the bond.
Related terms
- Counterparty RiskCounterparty risk is the danger that the other party to a financial contract fails to meet its obligations, especially relevant in over-the-counter derivatives and forwards.
- Credit SpreadA credit spread is the extra yield a bond pays over a comparable government security, compensating investors for the issuer's default risk.
- Sovereign Credit RatingA sovereign credit rating is a global agency's verdict on a country's ability and willingness to repay its debt, shaping how cheaply that nation and its companies can borrow abroad.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.