Why credit default swap matters
CDS separates credit exposure from bond ownership and supports hedging or relative-value trading. It also creates counterparty, basis, documentation, liquidity, and settlement risk.
How it is applied
Analysis covers reference entity, seniority, credit-event definitions, maturity, spread, notional, collateral, deliverable obligations, auction settlement, and counterparty netting. The protection buyer pays a periodic spread on notional amount in exchange for compensation after a defined credit event. Analysts review reference entity, seniority, maturity, restructuring clause, deliverable obligations, collateral, counterparty, and clearing. Index CDS can hedge or express views on a broad credit basket.
Portfolio example
An investor buys five-year protection on $10 million notional at 2% annually. Premium is roughly $200,000 a year until termination. If a covered default settles at 40% recovery, protection payment is approximately $6 million. An investor buys five-year protection on 10 million notional at 200 basis points, paying about 200,000 annually before accrual details. If a credit event occurs and auction recovery is 40%, settlement is approximately 6 million, subject to contract terms.
How to interpret it
A wider CDS spread generally signals higher required compensation for credit risk, but also reflects liquidity and technical demand. It is not a direct default probability. A wider CDS spread generally indicates greater perceived credit risk and required protection premium. Buying protection resembles a short credit position, but mark-to-market also responds to liquidity, technical demand, and recovery assumptions. Notional is not the same as maximum net economic exposure when positions offset.
Limitations and common misconceptions
Settlement may differ from cash-bond loss. Counterparty failure can coincide with credit stress, and restructuring definitions vary by contract and region. Basis can develop between CDS and cash bonds. Contract definitions may not match an investor’s specific loss, and counterparty or collateral risk remains. Jumps, auctions, deliverability, restructuring clauses, and sovereign intervention can cause outcomes that differ from a simple default-probability model. Premium accrual and upfront payments must be included in returns. Cleared and bilateral contracts can also impose different collateral timing and funding needs for investors.
Sources and further reading
- Futures GlossaryU.S. Commodity Futures Trading Commission
- Introduction to DerivativesCFA Institute