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What is a Credit Default Swap?

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What is a credit default swap?

A credit default swap (sometimes referred to by the acronym CDS) is a contract designed to protect against default on debt owed by a company, or in some cases, a country. "Swap" refers to the fact that the contract requires the buyer to make a series of payments to the seller and in exchange receives compensation if there is a "credit event" -- a fancy phrase for "default" -- involving the underlying. Hence, the "risk" of default is transferred or "swapped" for protection if there is a default. Important: the company or country underlying the contract (the "reference entity") is typically not involved in writing the contract.

Most credit default swaps are structured in the $10-$20 million dollar range and offer protection against a credit event for five years. Credit default swaps are quoted in basis points. They are not traded on an exchange, and this lack of regulation is perceived by some to be a weakness and a contributing factor to the 2007- 2008 debt crisis.

While CDS contracts are frequently written about in the mainstream media as "insurance" policies against default, they differ in a number of very important ways. First, imagine that your neighbor believes you are a terrible driver and were able to speculate on both the value of your automobile and the price of your auto insurance? That's essentially what speculators on CDS contracts are able to do. Your neighbor need not have a financial stake in either your car or your car insurance to speculate on whether you will crash your car, lowering its value, and potentially driving up the cost of your automotive insurance.

Of course, there are very good reasons for the existence of CDS contracts, too. A bank, for example, may hold the debt of a company and wish to hedge its exposure should the company suffer a credit event.
POSITION:  No positions in stocks mentioned.