Credit default swap

A credit default swap is a derivative contract that functions like insurance against a company or government defaulting on its debt. The buyer of protection makes regular payments to the seller, and in return, the seller agrees to make the buyer whole if the underlying borrower defaults or experiences some other defined credit event, such as a bankruptcy or a missed payment.

Credit default swaps were originally designed to let bondholders hedge the risk of a specific borrower, similar to how an investor might buy insurance on an asset they own. Over time, the market grew to allow investors to buy or sell protection on a borrower's debt without owning the underlying bonds, turning the instrument into a way to speculate on credit risk directly. The price of protection, quoted as an annual spread, rises when the market sees a borrower's default risk increasing and falls when that risk is seen as improving, making credit default swap spreads a widely watched, immediate signal of market sentiment toward a company's or country's creditworthiness.

Credit default swaps played a significant role in the 2008 financial crisis, when large volumes of protection had been sold on securities tied to mortgages, without sellers holding enough capital to pay out if defaults spiked across many borrowers at once. That episode led to greater scrutiny of the market and pushed much of the trading toward centralized clearing, which reduces the risk that one party's failure cascades through the whole system. For an investor, a widening in credit default swap spreads on a company's debt is often an early warning sign worth understanding alongside its bond prices and credit ratings, since the swap market sometimes moves ahead of other credit signals.