Definition
A CDS functions like insurance against bond default. The protection buyer pays periodic premiums (the CDS spread) to the protection seller. If the reference entity defaults, the seller pays the buyer the loss amount. CDS spreads are a real-time market indicator of perceived default risk—wider spreads signal higher risk.
lightbulb Example
An investor buys 5-year CDS protection on Company X at 200 bps annually. On a $10M notional, the annual premium is $200K. If Company X defaults with 40% recovery, the seller pays the investor $6M.
verified_user Key Points
- Functions like default insurance
- CDS spread reflects market-implied default probability
- Widely used for hedging and speculation
- Central to the 2008 financial crisis