What are Credit Default Swaps?

PREPARED BY: Chris Stanford 

DATE: 03/14/21


Credit default swaps (CDS) are indeed a popular financial instrument, and they have been widely traded in the derivative market. A credit default swap is essentially insurance that protects against the default of a bond. If the bond issuer defaults, the CDS holder receives a payout equivalent to the value of the bond. This instrument allows investors to mitigate the risk of not being paid if the bond issuer fails to meet its obligations.


One interesting aspect of CDS is that one does not need to own the underlying bond to purchase a credit default swap. This led to a problem during the financial crisis of 2008 when the market for CDS became much larger than the market for actual bonds. Speculators realized they could make small bets without owning the bonds and earn substantial payouts if the risk of default increased. Insurance providers ended up insuring more than they could afford to pay out.

Sellers of credit default swaps took on small amounts of risk for what appeared to be certain payouts. This situation is similar to writing a put option on a stock, where one collects the premium if the stock goes up but faces the risk of having to buy the stock if it goes down. While it can be a profitable strategy, there is significant risk involved, especially if one is overleveraged in the market.


To mitigate directional risk, major banks adopted a delta-neutral strategy by buying and selling credit default swaps simultaneously. However, some institutions, like AIG, only sold insurance and did not hedge their positions properly. AIG’s collapse was a significant issue because they had sold a substantial amount of credit default swaps they could not afford to insure. The collapse of AIG would have had a widespread impact on big banks in the US and Europe, leading the government to provide a revolving credit facility to AIG.

Banks appreciate credit default swaps because they offer them the ability to issue loans to riskier entities while mitigating some of the risks through CDS protection. Like regular insurance, incremental payments are made for a specified period, and the payout occurs when something goes wrong.


One of the major risks associated with the CDS market is counterparty risk. As depicted in the movie “The Big Short,” fund managers wanted to ensure that banks could make payments if the bonds defaulted. Assessing the financial risk of the underlying entity and the insurer is crucial for successful trading in the CDS market. Pricing CDS products can be complex, but they are typically based on the spread between the 10-year bond yield and the yield of the bond being insured. A higher spread indicates a higher price for the insurance.


It’s important to note that CDS trading is primarily available to high-net-worth individuals and large asset management funds due to the high risks and leverage involved. Exiting a CDS trade can be challenging since these contracts trade over the counter (OTC) without a transparent bid/ask spread. Buyers have to engage with potential sellers directly to obtain a quote.


CDS contracts can have different durations, impacting their costs. Some contracts have longer durations than necessary, allowing buyers to exit the trade if the situation changes. However, if the credit default risk is lower at that time, the buyer may owe more money. The value of CDS contracts can increase or decrease regardless of the solvency of the referenced company. If the market perceives a higher risk, the value of the insurance goes up, enabling CDS holders to sell their contracts at a profit.

The pricing of CDS is influenced by the credit spread, which represents the difference between the risk-free rate and the interest rate for a riskier entity. Investment banks often act as market makers in the CDS market.As of now, the global bond market is approximately $100 trillion, while the CDS market is around $110 trillion. These are some key points about credit default swaps, but if you have further questions or would like to discuss this topic in more detail, feel free to ask.