Credit Default Swaps (CDS) and Credit Derivatives › Credit Default Swaps (CDS) and Credit Derivatives

In the previous chapters on interest rate swaps, you learned how counterparties exchange cash flows to manage interest rate risk. Credit derivatives extend this concept to a different type of risk: the risk that a borrower defaults on their obligations. Among credit derivatives, the credit default swap (CDS) is the most important instrument, functioning as insurance against the default of a bond issuer or loan borrower.

The credit derivatives market grew explosively in the early 2000s, reaching over \$60 trillion in notional value by 2007. This growth was driven by banks seeking to transfer credit risk off their balance sheets, hedge funds speculating on corporate credit quality, and investors seeking exposure to credit spreads without owning the underlying bonds. The 2008 financial crisis highlighted these instruments when the near-collapse of AIG threatened the global financial system. You must understand how these instruments work, how they are priced, and their risks.