Can you explain, simply, what a credit default swap is?

BY busadmin  October 6, 2008 at 1:26 PM EST

Question/Comment: Can you explain, simply, what a credit default swap is?

Paul Solman: I sure hope so.

Basically, a credit default swap or “CDS” is an insurance contract to protect against bankruptcy.

Say you own a lot of Ford Motor Co. bonds, which Ford gave you in exchange for lending money to it. But you’re afraid Ford might go bankrupt, and not have enough money to pay back its bondholders. You can then buy a CDS that would pay you if Ford “defaulted” on its debts.

So you’ve swapped a small amount of money for a promise to be paid a much larger amount of money if a disaster occurs. Just as if you’d paid a premium on home insurance to protect against a disaster like the house burning down.

There’s lot more to it, of course.

Editor’s Note: For more on credit default swap check out Paul’s Oct. 7 segment on the subject.