Credit default swaps (CDS) are basically a put option on bonds. It’s a contract on a bond that insures against default or other drastic, price-lowering “credit event.”

Say you own some bonds or, simply, for business purposes wish to protect yourself from a downturn in bonds. You find a CDS seller and pay them a certain price. If the meets certain criteria, which can include restructuring, bankrupcty and credit rating downgrade as well as actual default, the CDS pays you the full or par value of the bond.

This process is often compared to insurance. You’re paying to insure, or hedge, yourself against the loss of bond value.

CDC prices are in basis points of the amount being insured. That’s $0.01 times the amount of the contract per year.

In practice, you as an individual don’t do this at home with a few bonds in your portfolio. The minimum amount is $10 million, so this contract is confined to financial institutions.

However, you could buy a CDS on a corporate bond that you don’t actually own. In a sense, this is comparable to selling a stock short. You believe that particular corporate bond is going to fail, so you buy the CDS to profit when that occurs.

Of course, credit ratings are a big factor in determining CDS prices. If all bond information is equal except Company 1 has an A credit rating while Company B has a B credit score, the CDS price for Company B will be a lot higher because the credit rating agency believes it to be a bigger credit risk.

CDS contracts do put a floor underneath the financial risk of owning a large portfolio of bonds. Of course, this price you pay for the CDS reduces your return from the bonds. But many fund managers accept this as a cost of doing business. Losing that money is acceptable because an unhedged bond default would be such a disaster to their fund.

It’s much the same as you accepting that you have to pay insurance on your house. Although nobody likes to, losing your home to a flood, storm, fire or other damage, while it may never happen, would be too much of a financial disaster.

However, generally accepted accounting principles (GAAP) require that owners of CDS contract mark them to market. That is, their market value can change on a daily basis, and you must adjust your balance sheet daily to reflect this. This is true even though you must value bond holdings at book value (which bears little relationship to current market value.)

Therefore, it can appear that the CDS contracts you own are worth more or less than the bonds you are using them to insure, and make your balance sheet more volatile.

The first CDS was created in 1997 by a team from JPMorgan. They sold the credit risk of Enron to the European Bank of Reconstruction and Development.

They are over the counter derivatives largely exempt from regulation by the U.S. Securities and Exchange Commission (SEC) because of the Commodity Futures Modernization Act of 2000. Sellers of CDS contracts are not required to maintain a reserve fund, but usually hedged their risk in the CDS markets.

It’s estimated that by 2007 their market size grew to $45 trillion dollars, but this shrank in 2008 to $38 trillion.

Some experts believe that credit default swaps helped to cause or increase the severity of the 2008 financial crisis, especially because Lehman Brothers and AIG sold a large number of CDS.