Credit Default Swaps

Credit default swaps (CDS) are a type of insurance against default risk by a particular company. The company is called the reference entity and the default is called credit event. It is a contract between two parties, called protection buyer and protection seller. Under the contract, the protection buyer is compensated for any loss emanating from a credit event in a reference instrument. In return, the protection buyer makes periodic payments to the protection seller.

In the event of a default, the buyer receives the face value of the bond or loan from the protection seller. From the seller’s perspective, CDS provides a source of easy money if there is no credit event. CDS was introduced by JP Morgan.