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Credit default swaps and credit derivatives

8 minute read · By Krishna Avadhani, Vestora Academy · Updated 18 October 2026

A credit default swap (CDS) is insurance-like protection against a borrower defaulting. The buyer pays a regular premium (the CDS spread, in basis points a year); if a credit event occurs, the seller pays the loss. CDS spreads are a live market gauge of default risk for companies and countries.

You can buy CDS protection without owning the bond ("naked CDS"), which lets traders bet on default. In 2008 AIG had sold huge amounts of CDS protection without enough capital and needed a US government rescue. Collateralised debt obligations (CDOs) built from subprime mortgages, and synthetic CDOs built from CDS, were at the centre of that crisis.

Other credit derivatives include CDS indices (CDX, iTraxx) and total return swaps on loans.

Key takeaways

  • CDS buyer pays a spread; seller pays out on default.
  • CDS spreads signal market-perceived credit risk.
  • AIG and CDOs show how credit derivatives spread systemic risk.

Check your understanding

1. A company's 5-year CDS spread rises from 100bp to 400bp. The market thinks default risk has...

  • Fallen
  • Risen
  • Not changed
  • Disappeared
Show the answer

Risen. Protection has become more expensive.

2. Why did AIG need rescuing in 2008?

  • It bought too many shares
  • It sold huge CDS protection without enough capital
  • Its CEO resigned
  • It issued too many options
Show the answer

It sold huge CDS protection without enough capital. Losses and collateral calls overwhelmed it.

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General education only, not financial advice. Examples are illustrations. Rules, tax settings and products change; check official sources.