If you understand that life assurance is something you take out in case you die then I am hopeful that we can help you come to terms with credit default swaps. A retail banking example would be where (hypothetically) a bank takes out a life assurance on a borrower so that if they die the loan is repaid.

This doesn’t happen in real life but it makes the point, that a person with a credit risk on their book (the borrower is a credit risk to the bank) can hedge against (take out life assurance) loss (non-repayment of the loan) via the borrower (reference entity) in the event of their death (credit event), quite a mess of parenthesis in that sentence!

A CDS is an insurance against credit risk, it is a privately negotiated bilateral contract. The buyer pays a fixed fee or premium to the seller for a period of time and if a certain ‘credit event’ occurs the protection seller pays the buyer.

A ‘credit event’ can be a payment default or bankruptcy of the company or country the insurance is taken out on (called a ‘reference entity’). If no credit event occurs while the swap is live the buyer continues to pay the premium until maturity. If an event occurs while the contract is live the seller must pay the buyer.