What is a Credit Default Swap? Definition, Pricing, and Example
A credit default swap (CDS) is a bilateral derivative contract in which a buyer pays periodic premiums to a seller in exchange for a one-time payment if a referenced borrower defaults on its debt obligations.
What is a credit default swap?
A credit default swap (CDS) is a bilateral over-the-counter derivative contract that transfers credit risk from one party to another. The protection buyer makes periodic premium payments to the protection seller. If a specified credit event occurs—typically default, bankruptcy, or failure to pay—the seller compensates the buyer for the loss. The contract references a specific borrower, known as the reference entity, and a specific debt issue, known as the reference obligation. CDS contracts trade in notional amounts of $5 million or more and settle either physically or in cash.
How a credit default swap is priced
The CDS spread is the annual premium, expressed in basis points of the notional amount, that the buyer pays. The spread reflects the market's view of default probability. A simplified pricing formula equates the present value of expected premium payments to the present value of expected default losses:
PV(premiums) = PV(expected loss)
where expected loss equals the probability of default multiplied by loss given default, discounted at the risk-free rate. The spread in basis points equals the annual premium per $10,000 of notional. For example, a 200-basis-point spread on $10 million notional means the buyer pays $200,000 per year, usually quarterly in arrears.
Worked example: single-name CDS on a corporate borrower
In August 2026, a five-year CDS on F (Ford Motor Company) trades at 180 basis points. A hedge fund buys $10 million notional of protection. The fund pays $450,000 per quarter (180 bps × $10 million / 4). Ford's bonds trade at 92 cents on the dollar. If Ford defaults and bonds recover at 40 cents on the dollar, the protection seller pays the fund the difference: $10 million × (1 − 0.40) = $6 million. The fund's total cost over five years, assuming no default, is $3.6 million in premiums. The contract has positive expected value only if the fund believes the true default probability exceeds the level implied by the 180-basis-point spread.
When traders use credit default swaps
Institutional traders use CDS to hedge credit exposure in corporate bonds, to express a directional view on a borrower's creditworthiness, and to arbitrage price differences between CDS and cash bonds. The CDS-bond basis—the difference between the CDS spread and the bond yield spread—signals relative value. A negative basis means CDS protection is cheaper than the bond's credit spread, which triggers basis trades. Hedge funds use index CDS products like CDX and iTraxx to take broad credit market positions.
Limitations and common misconceptions
CDS is not an insurance contract. The seller is not regulated as an insurer and can fail to pay. Counterparty risk is real; the 2008 financial crisis demonstrated that protection sellers like AIG could not honor obligations. CDS contracts do not require the buyer to own the underlying bond; naked CDS positions are legal and common. The CDS market is opaque; pricing varies by dealer and is not centrally cleared for all contracts. A CDS spread does not equal the probability of default; it embeds recovery assumptions, liquidity premia, and counterparty risk.