In some ways, they are extremely similar to car insurance. The amount you pay varies for every driver. An experienced driver isn't going to have to pay as much as a new teenage driver because there is a smaller chance that they are going to get into an accident and therefore a smaller chance that the insurance company is going to have to pay them. Similarly with credit default swaps, the higher the chance that your bond is going to default, the more you will have to pay to insure it. The amount that you have to pay is based on the credit spread of the bond you are "insuring." See this article for a description of credit spreads. Since credit spreads increase as the risk of default increases, the amount that you have to pay to be insured is also going to increase as the risk of default increases.
However, they are not exactly like insurance in all ways. When you get insurance for a car, you buy it from an insurance company, not your next door neighbor. Anyone can sell a CDS. Also, if you do not buy car insurance, you actually have to have a car. When you buy a credit default swap, you don't actually have to own the bond you are trying to insure. This makes credit default swaps a type of investment in their own right; you can buy/sell credit default swaps based on if you think a company is going to default. If the bond doesn't default, then your investment gave you a great return as you now have all the payments the buyer of your insurance paid. However, if the bond does default, then you lose money as you have to pay the buyer of your insurance the value of the bond. So, if you do some homework and decide that company A is in great shape and won't default on their bonds, then you could sell insurance for the bond and make money.
Now that you understand the basics, let's say that you want to buy a CDS for the full value of a 5 year bond for company XYZ from bank ABC. You're buying $1 million worth. The bond has a credit spread of 100 points. This means that you are going to pay $10,000 a year in premiums to bank ABC. There are 4 possible outcomes.
- XYZ never defaults. This means that you paid $50,000 to ABC and got nothing back from them.
- XYZ defaults after 3 years. This means you paid $30,000, but since ABC is covering the default, they will pay you the $1 million XYZ owed you. So you come out with $970,000.
- Now, after 1 year, the credit spread has widened to 200 basis points. You decide you want to make some more money so you offer ABC a CDS of the same bond with the new rate. This means that they will be paying you a premium of $20,000 a year. You will still continue to pay them the original $50,000. However, they will now pay you $20,000 x the remaining 4 years = $80,000. After all 5 years, you've made a $30,000 profit.
- This time the credit spread narrowed to 50 points after a year. Since the spread narrowed that means that the company is less risky and less likely to default. This means that option #1 is more likely. To offset your losses, you can do the same thing you did in option #3 and offer ABC a CDS. This time they will only be paying you $5,000 a year or $20,000 total. However, if XYZ doesn't default, you will only lose $30,000 to ABC rather than the $50,000 you would have lost.
Now I wrote about credit default swaps on a personal basis, however it is extremely hard to insure a bond yourself because credit default swaps are done on a large scale, such as selling and buying hundreds of millions of dollars in bond insurance. However, it is important to understand what a CDS is because that is one of the main problems AIG and other financial institutions are having.