Definition: A credit default swap (CDS) is a type of credit derivative, which seeks to protect a lender in the event that the borrower defaults by swapping the risk of default. In other words, it’s a type of insurance that helps the buyer of the swap reduce the risk of their investment (lending money to a borrower) by transferring the risk of default on the insurance company.
What Does Credit Default Swap Mean?
What is the definition of credit default swap? In a CDS, two counterparties trade the risk of default carried by a fixed-income security for periodic income payments until the maturity of the security. The holder of the security seeks protection against the risk that the issuer may default.
The counterparty assumes that the issuer will not default and that it will realize a profit from the income payments. If the bond issuer defaults, the counterparty will pay the holder of the security the par value and the remaining interest. A CDS may involve municipal bonds, mortgage-backed-securities (MBS), corporate bonds and emerging market bonds. Investors buy credit default swaps to hedge against the risk of default, for speculative purposes, and for arbitrage gains.
Let’s look at an example.
Example
Mark holds a 20-year bond issued by company A. The bond has a par value of $1,000 and pays an annual coupon interest of 8.5%. Mark is not much of an investor, and he doesn’t know how to evaluate the market moves. Being risk-averse, he is afraid that the issuer of the bond might default and Mark will lose his money.
Mark enters into a credit default swap with his best friend, Alex, and agrees to pay him $80 annually, which is the annual interest payments on his bond. Alex will pay Mark the par value of the bond. If the bond issuer does not default until maturity, Alex will realize a profit from the $80 annual payments for 20 years, i.e. $1,600. If the bond issuer defaults, Alex will pay Mark the remaining interest on the bond.
Mark, the bond holder, will gain protection against a potential default of the bond issuer. Alex, the counterparty, will gain the interest payments for assuming the credit risk of default.
Summary Definition
Define Credit Default Swap: CDS means a financial instrument that provides insurance for the lender in case the borrower doesn’t pay his debt.
