Credit Default Swap

A credit default swap is the simplest type of credit derivative. Basic CDS contracts are similar to insurance. They allow one party to buy protection against a company or country defaulting or restructuring their debt over a certain period of time. The buyer pays an annual fee in basis points based on a notional amount to the contract seller. If a default occurs the buyer can hand over the defaulted bonds to the contract seller and receive their par value. The contracts can also be cash settled with no transfer of bonds. CDS spreads are similar to regular corporate bond spreads in reflecting the market's view of default risk. The most commonly traded contract is a five-year one, but maturities range from one year to 10 years.

See also: Credit Derivatives, Collateralised Debt Obligation, http://www.ecb.int/pub/pdf/other/creditdefaultswapsandcounterpartyrisk2009en.pdf