"I view derivatives as time bombs, both for the parties that deal in them and the economic system ... the derivatives genie is now well out of the bottle and these instruments will almost certainly multiply in variety and number until some even makes their toxicity clear." - Warren Buffett

Credit default swaps (CDS) are swap contracts that act as insurance policies against a loan default. But unlike traditional insurance policies, credit default swaps can be purchased by anyone, including buyers who do not own or have any interest in the underlying loan being secured.

By the end of 2007, the CDS market had a notional value of some $62.2 trillion, according to the ISDA's Annual Market Survey.

How Credit Default Swaps Work (Simplified)

Suppose that you borrow $100 from your friend and agree to repay this debt in 10 years paying $5 per year in interest. Now suppose that your friend goes to a third party and signs a contract whereby the third party will pay $100 if you default in exchange for just $3 per year in premiums. If you default, the defaulted loan gets transferred to the third party who can try and recover the loan.

Sound simple? Let's bring this closer to how the real financial world works. Suppose that your former business partner is convinced that you're going to fail and decides to purchase the very same credit default swap from the third party. For just $3 per year in premiums, this former business partner could receive $100 if you fail and end up defaulting on your loan… even without an underlying interest.

Using Credit Default Swaps for Protection vs. Speculation

Credit default swaps are versatile derivatives that can be used in a number of different ways.

In the example above, we reviewed their use as an insurance policy (or hedge) against losses as well as a means of pure speculation. However, they are also being used for a variety of other purposes, including as a tool for capital structure arbitrage and sovereign debt bets.

• CDS Hedges. Credit default swaps can be used to protect or hedge a loan or bond against the possibility of default. In this case, the buyer enters into a derivate contract whose value moves in the opposite direction as their underlying position.
• CDS Speculation. Credit default swaps can be used for speculation by those that have no vested interest in the underlying security. In this case, the buyer enters into a derivative contract to provide him or her with a leveraged directional bet on the underlying security.
• CDS Arbitrage. Credit default swaps can be used as an arbitrage tool. In this more complex case, the buyer enters into a derivative contract to profit from inefficiencies between different parts of a company's or country's debt and/or capital structure.

Credit Default Swaps and their Role in Sovereign Debt

Sovereign credit default swaps have become an increasingly popular way to speculate on a country's future. While it would be difficult for the U.S. to default, since they could theoretically inflate their way out of debt, many other countries may not be able to do the same. For instance, Spain has defaulted more than 10 times since the 1500s and countries like Ecuador have defaulted as recently as 2008.

Sovereign credit default swaps are also commonly used as a barometer of risk. Often times, this risk is quantified by calculating spreads. These spreads are the difference between a country's CDS prices and that of a safer country or investment. For instance, credit default swaps in the European Union are often compared to Germany's robust economy.

Key Takeaway Points

• Credit default swaps are essentially insurance policies that involve the transfer of the loan to the insurer if a default occurs.
• There are many different ways that credit default swaps are used, but the three most common reasons are as a hedging tool, speculation tool, or arbitrage tool.
• Sovereign credit default swaps are commonly used as a barometer of risk in the form of CDS spreads, which compare rates with stable countries.