Credit default swap (CDS)

Credit default swaps, also known as default swaps, credit swaps and CDS, are the basic building block of the credit derivatives market. Almost all credit derivatives take the form of a credit default swap, adn most of these swaps are based on a standard legal contract know as a confirm.

An over-the-counter contract to transfer the credit risk of a reference entity, in which the protection buyer pays a premium and the protection seller makes a payment in the event of a default (credit event) by the reference entity. Depending on the terms agreed up front by the counterparties, settlement can be either physical (current market standard) or cash. In either case, the settlement amount is intended to compensate the protection buyer for the loss that it would have incurred had it owned the notional amount of the reference entity's debt.

CDS are leveraged instruments because the protection seller does not need to put any money down to earn a premium for the risk it takes. CDS are also referred to as unfunded instruments, since the protection seller does not need to raise money to buy credit risk.

See also single name credit default swap.