Definition

• A Credit Default Swap (CDS) is a financial derivative contract where the buyer makes periodic payments to the seller. In return, the seller agrees to compensate the buyer if a third party (a reference entity) defaults on its debt obligations.

Parties Involved

• Buyer (Protection Buyer): Pays periodic premiums to the seller for protection against default by the reference entity.
• Seller (Protection Seller): Receives premiums and agrees to pay the buyer if the reference entity defaults.

Reference Entity

• The entity whose credit risk is being hedged. It can be a corporation, a sovereign entity, or a basket of entities (index CDS).

Credit Event

• Default: Failure to meet debt obligations.
• Restructuring: Changes to debt terms due to financial distress.
• Bankruptcy: Filing for bankruptcy or entering insolvency.

Premium Payments

• The buyer pays periodic premiums (quarterly or annually) based on the reference entity’s creditworthiness, market conditions, and default risk.

Settlement

• Physical Settlement: Delivery of the actual defaulted debt securities.
• Cash Settlement: Payment of the difference between the face value and recovery value of the debt.

Uses of CDS

• Risk Management: Hedging credit risk in investment portfolios.
• Speculation: Betting on changes in credit spreads or creditworthiness.
• Portfolio Diversification: Gaining exposure to credit risk without owning underlying debt securities.

Market Size and Regulation

• Market Size: Significant, with contracts traded over-the-counter (OTC) among institutional investors and financial institutions.
• Regulation: Varies by jurisdiction, focusing on transparency, systemic risk reduction, and market integrity.