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Credit Default Swap (CDS): Simplified

Updated: Nov 13, 2020

A CDS is a derivative that guarantees investors against a risk. It’s like insurance in case of a credit event.

You swap the risk of credit default from a company with another company.

A credit event can be a bankruptcy, payment default, or inability to honor the terms. A credit event is a trigger to settle the contract.

Suppose you bought a bond from an investment bank, take for example a CMO (Collateral Mortgage Obligation). Now CMO is a risky investment but gives better returns so you want to purchase it anyway.

You can ensure your money in case of a credit event with a bond seller. For that, you have to buy CDS from a third party company like insurance. It can be a one-time payment or

multiple small transactions like EMI.

The company that sold you the CDS ensures you the money in case of a credit event with bond seller company.

Because of CDS, investors started to buy bonds mercilessly but it also made them careless. CDS became a time ticking bomb that blew up the global economy in 2008.

Actually CDS was not the root cause of the 2008 financial crisis, it was corruption. Companies that made the bond & agencies that rated the underlying debts were so hungry for profit that they looked over the effect of it over a course of a period.

In 2008, the bond market was at the peak, so was the CDS. When the biggest bond seller company filed for bankruptcy it created chaos in the market. Suddenly all CDS buyers were eligible for the contract settlement and that amount was a lot over what the whole company valued.

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