Credit Default Swaps (CDS)
Credit Default Swaps (CDS) are credit derivatives whose payoffs are triggered by a credit event, such as bankruptcy, restructuring and failure to pay, which are the three most common realisations of the term. CDSs represent more than half of the entire credit derivative market.
In practical terms, the Default Swap buyer will receive protection during a credit event on the underlying reference entity (e.g. a corporate bond) from the Default Swap Seller, who receives a periodic coupon payment in return for protection. In a CDS, the credit risk of the underlying reference entity is assumed by the seller of the swap. Depending on the type of settlement agreed at the inception of the contract, the Default Swap Seller pays the Reference Notional * (1 – recovery rate) to the buyer (cash settlement) or the buyer delivers the underlying to the seller and receives the reference price agreed at the inception of the contract (physical settlement)