A Credit Default Swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. Essentially, it is a form of insurance against the risk of default by a borrower (known as the reference entity).

Parties Involved

1. Protection Buyer: Pays a periodic premium (like an insurance premium) to the protection seller.
2. Protection Seller: Agrees to compensate the protection buyer if a credit event (e.g., default, bankruptcy, or restructuring) occurs.

Some Key Points in the Mechanics

• Reference Entity: The borrower whose credit risk is being insured (e.g., Company A).
• Notional Amount: The face value on which payments and contingent payouts are based (e.g., $10 million).
• Premium Payments (CDS Spread): The Protection Buyer pays a periodic amount (often quoted in basis points per year on the notional) until either the CDS matures or the reference entity defaults.
• Credit Event: If a default happens, the Protection Seller compensates the buyer for the loss, typically (Notional − Recovery Value).

How It Works:

1. The protection buyer pays periodic premiums (referred to as the CDS spread) to the protection seller for the duration of the contract or until a credit event occurs.

2. If a credit event occurs:

   The protection seller compensates the protection buyer for the loss incurred due to the default. This is often the notional amount minus the recovery value of the reference entity’s debt.

Valuation of a Credit Default Swap

The valuation of a CDS involves two primary components:

1. Premium Leg: Represents the fixed periodic payments made by the protection buyer to the protection seller.