Credit Default Swap

A credit default swap is a type of swap in which the lender of a loan is given a guarantee against the non-payment of the loan. The seller of the CDS provides insurance to the lender in the sense that if the borrower defaults, the CDS buyer will be paid back by the CDS seller. The buyer of a credit default swap pays a premium on a monthly basis for insuring against a debt default. CDS is mainly used for fixed income products like market bonds, corporate bonds, and mortgage-backed securities.

Example:

Suppose an investment bank owns $1 million corporate bonds issued by a private housing firm which pays an interest of 6% per annum. If there is a risk that the housing firm may default, the investment bank can buy a CDS from an insurance company. The investment bank will pay an interest of 1% per year on $1 million to the insurance company as the insurance premium. If the private housing firm doesn’t default, the insurance company gains the interest from the investment bank and pays nothing out. While if the private housing firm defaults, then the insurance company has to pay a compensation of $1 million to the investment bank.