A Credit Default Swap (CDS) is a financial instrument that is effectively insurance on a bond. The idea behind them is that the owner of a CDS pays a certain amount per year (interest rate basis points) and if the asset that is backed by the CDS defaults, the CDS owner is paid off.

A bond is valued at 100 (par) and the CDS will pay the difference between the market value of the bond and par at the time of default, i.e. if bondholders receive 20 cents on the dollar the CDS will pay 80 cents per dollar.

Originally they were used as an insurance or hedging policy, but due to the fact that you do not have to own the asset in order to buy a default swap on it, they have become tools for relatively cheap speculation.

For example, if an investor believes that a corporation is going to default on its debts, they could buy credit default swaps from an investment bank. The investment bank would charge a certain amount per year in order to offer the insurance. If the investor bought swaps on $10 million worth of corporate bonds and the investment bank charged 250 basis points for 3 years, the investor would have a maximum risk of $750,000 (2.5% x $10,000,000 x 3) for a maximum gain of $10 million.

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