credit default swap

credit default swap, a financial agreement that is used to transfer credit risk between two parties. A credit default swap (CDS) contract is bound to a loan instrument, such as municipal bonds, corporate debt, or a mortgage-backed security (MBS). The seller of the CDS agrees to compensate the buyer in the event of the loan’s default until the maturity date of the CDS contract. The buyer in return makes regular premium payments to the seller during this time.

In many respects, a CDS is similar to an insurance contract in which the buyer pays premiums in exchange for default protection from the seller. An important difference is that in a CDS the buyer need not have “insurable interest” in the underlying loan instrument; i.e., a buyer can purchase a CDS for a loan that belongs to another party.

CDSs are traded over the counter, and they are widely used by institutional investors and portfolio managers to hedge against default risk.