Credit Default Swaps (CDS) are a type of financial derivative that acts as insurance against credit risk. They are contracts between two parties where one party (the protection buyer) pays a regular premium to the other party (the protection seller) in exchange for a promise to be compensated in case of a credit event, such as default, bankruptcy, or debt restructuring, involving a third party (the reference entity).
CDS can be used to hedge credit risk, or to speculate on the creditworthiness of a particular reference entity. For instance, a bank that has lent money to a borrower can use CDS to protect itself against the risk of default by purchasing protection from a CDS seller. On the other hand, a hedge fund that believes that a particular company is likely to default can buy protection from a CDS seller and make a profit if its prediction comes true.
The value of a CDS is linked to the creditworthiness of the reference entity, and is typically expressed in basis points (bps) per year of the notional value of the contract. If the creditworthiness of the reference entity deteriorates, the price of the CDS will increase, reflecting a higher probability of default and a higher payout in case of a credit event. Conversely, if the creditworthiness of the reference entity improves, the price of the CDS will decrease, reflecting a lower probability of default and a lower payout in case of a credit event.
CDS have been at the center of controversy during the global financial crisis of 2008-2009, as they were used by some market participants to speculate on the potential default of certain mortgage-backed securities and exacerbate the systemic risk in the financial system. As a result, regulators have implemented tighter regulations on the use of CDS, requiring greater transparency, reporting, and risk management practices.