What is a CDS: Answer Guide 2027
A credit default swap (CDS) is insurance-like protection against a borrower's default — the buyer pays a periodic premium and receives a payoff if the reference entity defaults or restructures. In a what is a CDS interview question, explain the structure, the spread-as-signal logic, and the difference between hedging and speculation.
CDS Interview Questions: What They Test
The mechanics: the protection buyer pays a running spread (quoted in basis points per year) on a notional amount; if a credit event occurs — bankruptcy, failure to pay, restructuring — the seller compensates the buyer for the loss. Settlement is typically through an auction determining the recovery value.
The spread is the market's real-time credit verdict: a 500bp CDS spread means it costs 5% per year to insure the debt — wider spreads signal higher perceived default risk. Interviewers want the two-sided usage: bondholders hedge existing exposure, while speculators buy "naked" protection to short credit without owning the bond — the controversial use that amplified 2008 debates.
How to Answer a What is a CDS Interview Question
- Define it. "A contract transferring default risk: buyer pays a premium, seller pays out if the reference entity suffers a credit event."
- Explain the spread. "Quoted in basis points — wider means the market sees more default risk; it is a live credit barometer."
- Walk a credit event. "Default triggers an auction setting recovery value; the seller pays par minus recovery on the notional."
- Distinguish hedging from naked. "Holders hedge real exposure; speculators buy protection without owning bonds — effectively shorting credit."
Common Mistakes in CDS Interview Answers
- Calling it insurance. Economically similar, but CDS sellers need no insurable interest — the legal and regulatory distinction matters.
- Forgetting counterparty risk. The protection is only as good as the seller — AIG's near-failure taught this lesson permanently.
- Ignoring the basis. CDS spreads and bond spreads can diverge (the CDS-bond basis) — traders live in that gap.
CDS questions test credit-derivatives literacy — structure, spread logic, and the 2008 lesson in one answer.
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FAQ
Q: What triggers a CDS payout? A: Defined credit events — typically bankruptcy, failure to pay, or restructuring of the reference entity's obligations.
Q: What does a CDS spread of 300bp mean? A: It costs 3% of the notional per year to buy default protection — a market gauge of perceived credit risk.
Q: What is naked CDS? A: Buying protection without owning the underlying debt — a speculative short on the reference entity's creditworthiness.
Q: How are CDS settled after default? A: Usually through a market-wide auction that establishes the recovery value; the seller pays the difference between par and recovery.
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