Credit Default Swap

Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset's market value following the credit event.

Example of a single name credit default swap
An investor who wants to take a view on France Telecom might sell credit default swap protection. In May 2006, dealers quoted five-year credit default swap spreads on France Telecom at 37/39 basis points (bp, hundredths of a percentage point).
This means the dealer quotes 37bp for a trade where the investor sells five-year protection and the dealer buys protection, and 39bp for a trade where the investor buys protection. (The difference between the two quotes is known as the ‘bid-offer spread’.)
On a typical trade size of €10 million, the protection seller would receive €37,000 a year, usually in four quarterly payments. Conversely, the investor could buy protection for 39bp, paying €39,000 a year.
If France Telecom defaults during the life of the trade and, following the default, the value of the company’s debt falls to 40% of face value (the ‘recovery rate’), the protection seller will compensate the protection buyer for the €6 million loss.