Credit default swap (CDS)
Quantitative Finance glossary · Quantitative Finance
Definition
OTC contract in which the protection buyer pays a periodic spread s on a notional N to the protection seller in exchange for (1-R)· N contingent on a credit event of the reference entity (where R is recovery). At inception the par CDS spread satisfies the credit triangle approximation s ≈ h,(1 - R), where h is the hazard rate. ISDA's 2009 'Big Bang' standardised running coupons (100/500 bp) plus an upfront — a CDS now trades on upfront, with par-equivalent spread reported. Standardised contracts cleared via ICE Clear Credit.
Credit default swap (CDS) in plain English
A credit default swap is basically insurance on a loan or bond: you're worried a company (or country) might fail to pay back what it owes, so you pay a small fee every year to someone who promises to cover your losses if that company defaults. The buyer pays a periodic 'spread' (like an insurance premium) on a notional amount N; if the company has a 'credit event' (misses payments, goes bankrupt), the seller pays out roughly (1-R)· N, where R is the fraction you'd still recover on your own. A quick rule of thumb ties the fair premium to how likely default is: s ≈ h,(1-R), where h is the yearly default probability — so riskier borrowers cost more to insure. Since a 2009 industry overhaul (the 'Big Bang'), these now use standard fixed coupons plus an upfront payment and are routed through a central clearinghouse to reduce the risk that the insurer itself blows up.
Also called: CDS
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