Credit Default Swap
Definition
A financial contract where one party pays a periodic fee to another in exchange for protection against default on a reference debt instrument.
Explanation
CDS function like insurance on bonds. The protection buyer pays a quarterly premium (the CDS spread) to the protection seller. If the reference entity defaults, the seller pays the buyer the face value of the bond minus its recovery value. CDS spreads are widely used as a real-time measure of credit risk — rising spreads signal increasing default probability. CDS played a central role in the 2008 crisis when AIG sold massive amounts of CDS protection on mortgage-backed securities and couldn't honor its obligations.
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