Let's concentrate now on the single name Credit Default Swap, or CDS As the name suggests.

This is a swap and acts Very much like an interest rate swap in that there are two Legs, One paid and one received, and two counterparties Who Both commit to Pay or receive each leg. The Important difference With A CDS is That one leg, what we might call The default leg, labeled In the diagram as one minus recovery Is Only paid in the event that a reference entity Defaults And may therefore never get Paid. The other leg called The premium leg Or the CDS spread Is paid until the swap terminates. When it reaches its natural maturity Date, or there Has been a default.

Let's Think about an example.

Say we have a five year CDS, where the CDS spread Is 1% per year, and the CDS Is Targeted on a particular senior bond issued by a corporate issuer.

As with other types of swap, we Have a notional amount upon which the payments are based.

So let's say That is $10 million, The Swap begins, and the protection buyer, The Left hand side in the diagram, makes quarterly payments of 1% of notional totaling $100,000 per year, ignoring day count To the Protection seller on the right.

If The reference entity does not default, This Exchange will carry on for five Years with the buyer Paying a maximum total of $500,000 To the seller.

However, let's say that at Some point in the life of the swap, the reference entity Defaults On their bond.

At this point, the Swap stops All premium that has accrued up to this point is paid, and a one off payment on the default Leg is paid by the seller to the buyer.

The default leg size is calculated as One minus the determined recovery rate on the bond Multiplied By the notional of the Swap. So for example, if the recovery Is determined to be 40%, The default Leg payment would be 60% Of $10 million, Which Is $6 million.

We can see that similar to insurance, The Buyer here is paying a series of small regular payments and may receive a much larger one-off payment at some future point. Note that With CDS, we do use The terms buyer and seller Rather Than payer and receiver with the name reflecting, who is buying and selling credit Protection.