Credit Default Swaps Explained

from Wealth Cycles:

A credit default swap (CDS) is a derivative referencing the credit of the ‘reference entity.’ A derivative is simply a contract.

You can think of a credit default swap (CDS) as kind of like auto insurance. Let’s say you are buying car insurance for yourself:

• You purchase car insurance from an insurance company
• You will make periodic payments to the insurance company
• If you do not get in an accident, the insurance company keeps the money
• If you do get in an accident, the insurance covers the cost of the damages

A CDS is similar but not identical. One difference is, with a CDS you are buying insurance to protect against a credit event of the reference entity:

• The buyer will purchase a CDS to insure against the reference entity
• The CDS buyer will make periodic payments to the seller
• If the reference entity does not suffer a credit event, as defined by the ISDA, the CDS seller keeps the payments
• In the case of a credit event, the CDS buyer receives full value, and the CDS seller typically receives the defaulted security from the CDS buyer (as an auto insurer would receive a totaled vehicle)

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