credit default swaps (CDS)

How do credit default swaps work?

Don’t let anyone tell you CDSs are too complex for you to understand – they’re not much different from the insurance you purchase on your home or your car, except it’s bonds that are being insured.

Say you are the nervous owner of $10 million in face value of Morgan Stanley (NYSE: MS) bonds and you fear the bank could go belly-up, putting the value of your bonds at risk. One solution is to purchase protection in the form of a credit default swap.

Last Thursday, credit default swaps on Morgan Stanley’s debt were trading at 975 bps. In plain terms, in order to insure $10 million in face value of bonds against the risk that Morgan Stanley won’t meet its obligations, credit default swap buyers were willing to pay an annual premium of:

($10,000,000) * (9.75%) = $975,000

This premium is on top of an up-front payment -- last Monday, that sum was a whopping 12% of the total face amount being insured. In return, the credit default swap seller guarantees the bonds’ payments or their value in the event of default or bankruptcy.