Credit Default Swap (CDS)

A CDS works much like insurance on a bond or loan. The buyer of protection pays a regular premium, called the CDS spread. If the borrower, known as the reference entity, defaults or experiences another specified credit event, the seller of protection compensates the buyer for the loss.

For example, an investor holding 10 million of a company's bonds could buy CDS protection at a spread of 150 basis points, or 1.5%, paying 150,000 a year. If the company defaults and the bonds become worth only 40% of their face value, the protection seller would pay the investor about 6 million to cover the loss.

CDS spreads are widely watched as a measure of how risky the market considers a borrower. A higher spread indicates a higher perceived risk of default.

Unlike insurance, CDS can be bought by investors who do not own the underlying debt, allowing them to speculate on a borrower's creditworthiness. CDS played a major role in the 2008 financial crisis, when the insurer AIG had sold huge amounts of protection it could not pay out, requiring a government rescue. Regulations now require many CDS contracts to be cleared through central clearing houses and reported.