trading

credit default swap

A financial derivative that functions like insurance on a bond — the buyer pays periodic premiums and receives a payout if the bond issuer defaults.

Example

“Investors used credit default swaps to bet against mortgage-backed securities before the 2008 financial crisis.”

Memory Tip

CDS = insurance on a bond. Pay premiums; collect if the issuer defaults.

Why It Matters

Credit default swaps affect the broader financial system and can impact bond prices, interest rates, and overall market stability. Understanding them helps investors recognize hidden risks in financial markets and how insurance on debt can signal trouble in the economy.

Common Misconception

Many people think credit default swaps are only used to protect against defaults, but they are also used for speculation. Investors can buy these swaps betting a company will fail even if they do not own the underlying bond, which can actually increase systemic risk.

In Practice

If you own a corporate bond issued by Company XYZ worth 1 million dollars, you could buy a credit default swap for 5,000 dollars per year. If Company XYZ defaults within 5 years, you receive 1 million dollars from the swap seller, offsetting your bond loss while having paid only 25,000 dollars in total premiums.

Etymology

CREDIT (loan quality) DEFAULT (failure to pay) SWAP (exchange of payments). A SWAP contract protecting against CREDIT DEFAULT.

Common Misspellings

credit default-swapcredit defualt swapcredit default swapp

Related Terms

derivative hedge counterparty risk

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