Credit Default Swap (CDS)

A credit default swap (CDS) is a derivative contract that transfers the default risk of a reference entity (a company or government) from one party to another. The protection buyer pays a periodic premium (the CDS spread, in basis points); if a defined credit event occurs — bankruptcy, missed payment, restructuring — the protection seller compensates the buyer for the loss. It functions as insurance on a bond.

The CDS spread is a clean, continuously traded measure of default risk that often moves faster than cash bond spreads. Widening CDS signals deteriorating creditworthiness; sovereign CDS (on countries) is a closely watched gauge of fiscal stress. CDS can be traded without owning the underlying bond — a "naked" position used to speculate on or hedge credit deterioration.

The practical caution: CDS amplified the 2008 crisis because sellers like AIG wrote enormous protection without capital to back it. Post-crisis reforms pushed standardized CDS through central clearinghouses, but the instrument remains a powerful — and watched — credit risk barometer.