The king of derivatives in the credit market is the credit default swap, or the CDS. A credit default swap is a derivative contract through which two parties transfer the credit exposure to bonds between them. It's very much like an insurance policy on a bond. A CDS is typically defined through a number of key terms, and here are some of those. The buyer is the buyer of credit protection, or the buyer of insurance. The seller is the seller of credit protection, or the seller of insurance. The notional is the face value of the bonds that are being insured. The reference obligation is the underlying bond that you're insuring. The premium is the premium payable in basis points of the notional amounts. This is usually paid quarterly. It's also known as the spread or the fee. Settlement is usually in cash. And the term is defined as the duration of the contract. So very much like an insurance policy on a bond. Unlike a normal insurance policy though, and this is important to remember, you can buy insurance on a bond that you do not own.

Here's a simple example of a CDS trade. The terms have been defined here on the left. The buyer of insurance is Birkdale. The seller in this case is a company called Augusta. The notional of the insured bonds is 10 million dollars. And the bonds are issued by Muirfield Plc. And they're a five-year bond. The premium, as I mentioned, payable quarterly, is 55 bibs per annum. Settlement has been defined as cash, and the total term of the insurance contract or the CDS is one year.