Credit Default Swap - Trading and Hedging Default Risk

By EC Assets Research Team, Fixed Income Research · Published 20 May 2026 · Updated 28 May 2026

Credit Default Swap — A credit default swap (CDS) is insurance against a borrower defaulting: the protection buyer pays a periodic spread and receives (1 − recovery) × notional if a credit event occurs. It lets investors take, hedge, or short credit risk on a name without owning its bonds, and its spread is a near-pure, real-time gauge of default risk.

What a Credit Default Swap Is

A credit default swap (CDS) is insurance against a borrower defaulting. The protection buyer pays a periodic premium - the CDS spread - to the protection seller, and in return the seller compensates the buyer if a defined credit event (default, bankruptcy, restructuring) occurs on the reference entity. It lets an investor take or transfer credit risk on a name without owning its bonds at all, which is why it became the central instrument of the modern credit market.

The CDS spread, quoted in basis points per year on the protection notional, is a near-pure read on the market's view of an issuer's credit risk - cleaner than a bond's cash spread, because it is unaffected by the bond's coupon, the funding cost of holding it, or where it trades relative to par.

How the Cash Flows Work

Two legs run until maturity or a credit event:

• Premium leg: the buyer pays the spread, quarterly, on the notional - e.g. 200 bps a year on 10m is 200,000 a year, paid 50,000 per quarter.
• Protection leg: on a credit event, the seller pays the buyer the loss given default, (1 − recovery rate) × notional, usually settled through an auction that sets the recovery price.

Since the 2009 "Big Bang" standardisation, single-name CDS trade with fixed coupons (typically 100 bps for investment grade, 500 bps for high yield) plus an upfront payment that reconciles the fixed coupon with the market spread - which made contracts fungible and far easier to net and clear.

The Spread-to-Default Intuition

A rough but illuminating relationship links the spread to default risk:

CDS spread ≈ probability of default × (1 − recovery rate)

so the market-implied annual default probability is approximately the spread divided by (1 − recovery). It is an approximation - it ignores the risk premium and timing - but it captures why a name trading at 600 bps is pricing far more distress than one at 60 bps.

Worked Example

Buy five-year protection on a 10m notional at a CDS spread of 200 bps, assuming a 40% recovery rate.

Premium paid: 200 bps × 10m = 200,000 per year (50,000 per quarter) until maturity or default. Payout on default: (1 − 0.40) × 10m = 6,000,000, against which the buyer delivers the defaulted bonds (or cash-settles to the auction price). Market-implied default probability ≈ 0.02 / (1 − 0.40) ≈ 3.3% per year.

If the issuer never defaults, the buyer simply pays the premium and the protection expires worthless - the cost of insurance that was not needed. If it defaults in year two, the buyer has paid ~400,000 and receives ~6,000,000.

Single-Name, Index, and the Basis

• Single-name CDS reference one issuer.
• CDS indices - CDX in North America, iTraxx in Europe - bundle many names into one liquid, tradable contract, and are the most efficient way to take or hedge broad credit exposure.
• The CDS-cash basis is the gap between an issuer's CDS spread and its bond's cash spread. It should be near zero by arbitrage; when it is not, relative-value desks trade the two against each other.

[!key] A CDS turns credit risk into a tradable, fundable instrument. You can be short a company's credit (buy protection) without finding and shorting its bonds, hedge a loan book, or express a macro view through an index - all without touching the underlying debt.

Why It Matters for Institutional Investors

• Hedging. Banks and bond portfolios buy CDS to hedge issuer or sector exposure without selling the underlying bonds - useful when the bonds are illiquid or held for relationship reasons.
• Expressing views and going short. CDS is the practical way to short credit. A hedge fund bearish on a company or sector buys protection; the famous "Big Short" was, in large part, buying CDS on mortgage exposure.
• A real-time risk gauge. Single-name and index CDS spreads move continuously and are watched as a live measure of perceived default risk - often reacting faster than the cash bond market.

[!warning] Selling CDS protection is structurally short credit and short volatility: steady premium income, then a large, correlated loss when defaults cluster in a downturn. The 2008 crisis showed how concentrated, under-collateralised protection selling can transmit one firm's failure across the system. Treat written CDS as the tail-risk warehouse it is, and watch counterparty and collateral terms as closely as the spread.

References

1. Hull, J. C. (2022). Options, Futures, and Other Derivatives (11th ed.). Pearson. Chapter 25.
2. Duffie, D., & Singleton, K. J. (2003). Credit Risk: Pricing, Measurement, and Management. Princeton University Press.
3. International Swaps and Derivatives Association (ISDA). Credit Derivatives Definitions and the 2009 "Big Bang" Protocol.
4. O'Kane, D. (2008). Modelling Single-name and Multi-name Credit Derivatives. Wiley.