A “credit default swap” (CDS) is an agreement that can be included in the family of the so-called credit derivatives.
It is an instrument mainly used by banks in order to hedge against credit risk, but also for speculative reasons.
A CDS implies two counterparties, the protection buyer and the protection seller. The latter is obliged, in this contract, to pay the flows related to a specific credit (reference obligation) in case of a credit event of the reference entity. The former will pay a certain premium for buying this sort of protection for his/her credit.
Let’s imagine a bank A that has in its portfolio a bond issued by a company B. Bank A wants to protect itself from a credit event to company B. Indeed, if a credit event occurs to company B, this company will
probably face difficulties in repaying its debt: that is what bank A wants to avoid. Therefore, for instance, bank A could enter into a CDS with another bank (let’s call it bank C) that is going to pay the flows related to the bond issued by company B in case of default of the issuer. In order to enter into this CDS contract, bank C will receive a premium calculated on the notional of the reference obligation that is in the book of bank A.
The difference with a common swap is that with a CDS there is only one necessary payment (the premium paid by the protection buyer to the protection seller), because the protection seller acts only if the credit event occurs.
Actually, a CDS can be viewed as a type of insurance on the default of the reference entity.
Obviously, the more likely the market considers the default of the reference entity, the higher the premium requested by the protection seller will be. The length of a CDS is typically 5 years, but since it is an over-the-counter agreement,any
length can be chosen.
The graph below represents the flows that characterise a CDS contract:

The CDS market is a very important benchmark on how the market perceives and evaluates the default risk for a specific company. It has become more reliable than ratings and it varies continuously according to the market.
Editor: Ugo TRENTA

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