This is an excellent introduction to CDS’s, aimed at developers.
Now consider the case where we buy a General Motors bond. We then enter into a credit default swap to the maturity of the bond as well. This acts as insurance against General Motors defaulting on the bond. We receive interest from the General Motors bond, but pay some of it away in insurance on the credit default swap. Suppose the interest rate on a US Government bond is 5% and the interest rate on a General Motors bond of the same maturity is 8%. We’d expect the premium on a credit default swap on General Motors for the same period to be about 3%. Note that the 3% premium is also called the ‘spread’ on a credit default swap, since it is the spread between the government bond and the corporate bond interest rates.
In summary, a credit default swap is a contract where one party to the contract pays a small periodic premium to the other, in return for protection against a credit event (financial difficulty) of a known reference entity (company).
I wish there were more articles on financial products like this, written in plain English for non-Quants.
musingstudio 