Credit Default Swap (CDS) is a derivative contract that enables the transfer of credit risk without transferring the actual credit asset.

CDS transfers credit risk by buying and selling what is called "protection". Credit risk can be consigned by buying protection; the buyer of the protection pays the counter value of the credit risk (called "premium") to the seller.

The premium of a CDS contract is generally displayed as the interest rate (annual base, by basis point) on the notional principle amount. The value of the notional principle amount multiplied by the interest rate, adjusted by the number of days to the premium payment date is calculated, and paid to the protection seller from the protection buyer.

<premium calculation example>
Notional principle amount: 500 million yen
Premium (interest rate): 12 bp (basis point) annually
Premium payment dates: the 20th of March, June, September and December
Method of adjusting number of days: the actual number of days to the payment date divided by 360 days.
e.g.) (case where number of days to payment is 90 days)
notional principle amount x interest rate x (number of days / 360 days)
=500 million yen x 12 bp x (90/360)
=150,000 yen

CDS contracts, in general, are trades on credit risk of a specified entity (called "referenced entity").

In the case of a referenced entity's bankruptcy, etc. (called "credit event"), the protection buyer hands over the relevant credit to the protection seller, and at the same time accepts the relevant amount of capital for the credit. By doing so, the protection buyer can avoid losses due to credit events.

In trading CDS's, the counterparties can transfer only the credit risk amongst themselves without transferring the credit asset of the referenced entity^* (regardless of possession of the credit of the referenced entity).

In the case where the protection buyer is the creditor to a referenced entity, the protection buyer can hedge the credit risk on the credit for a referenced entity while maintaining the debtor-creditor relationship with the entity. Other ways to hedge credit risk include directly handing over credits such as loans, but this requires adjusting or making new arrangements to the debtor-creditor contractual relationship. In CDS contracts, an agreement between the trading counterparties alone is needed for the transfer of credit risk, so the trade can be done more easily.

Furthermore, the protection seller of a CDS trade can take up an entity's credit risk and earn from its premium without entering into a debtor-creditor relationship with the referenced entity. If credit risk is taken up in another method such as issuance of loans or purchase of corporate bonds, the capital for the full principle amount (or face value) will be needed. In the case of selling protection of CDS trades, earnings can be sought by with only a portion of the notional amount or value (collateral, etc.)

*Transfer of referenced entity credit can occur in CDS contracts upon settlement under a credit event.