What are credit default swaps?
A credit default swap (or CDS) is linked to, but not sold by, a corporation or a government that has issued bonds on the capital markets.
The seller of the CDS, a bank or other financial institution, receives regular payments – like an insurance premium – from the buyer to cover the possibility that the bond issuer will fail to meet repayments and thereby default.
Here's how it works: You own a five-year bond issued by Delta Corp which has a par value of $1,000 with a coupon that pays interest of $100 a year. You seek protection – fearing Delta Corp may default on the bond – and so buy a CDS from Beta Bank. The bank charges you $20 a year until either Delta Corp’s bond matures and repays you in full, or until Delta Corp defaults.
If the bond reaches maturity, you’ve redeemed the $1,000 par value and received $500 in interest payments, minus the $100 (five annual $20 payments) you paid to Beta Bank for the CDS.
But let's say Delta Corp defaults three years after the bond is issued. Under the terms of your CDS Beta Bank pays you the par value of the bond plus the remaining two years of interest payments and the CDS contract is terminated.
You don’t need to own Delta Corp’s bond to buy the CDS that references it. You might be speculating on the creditworthiness of Delta Corp: you believe the company is in a weak financial position and that default is likely, so you buy the CDS from Beta Bank who will still pay the face value of the bond regardless of whether you own it. These transactions are sometimes called ‘naked CDS’.
Who wins?
The CDS issuer wins if the bond reaches maturity – Beta Bank in the example would receive $100 from you over five years, and you cede some of your overall profit on the bond.
The CDS issuer loses if the bond defaults: you’ve received $100-a-year yield off the bond up to the point of default, and Beta Bank pays you the $1,000 full face value of your bond plus the remaining interest payments – $200 if there was two years left until maturity. In the case of naked CDS, you win only if the bond goes into default.