What does the CDS spread represent in a credit default swap agreement?

The CDS spread is a key component in understanding the pricing and risk assessment of a credit default swap agreement. It represents the premium or fee paid by the buyer of the CDS to the seller, typically expressed in basis points per year. This premium compensates the seller for taking on the risk of default on the underlying credit instrument, such as corporate debt or sovereign bonds.

A wider CDS spread indicates a higher perceived risk of default, reflecting greater uncertainty about the creditworthiness of the underlying entity. Conversely, a narrower spread suggests lower risk. This premium is critical in the valuation of the CDS and is influenced by factors such as the credit rating of the reference entity, market conditions, and tangible factors related to credit risk.

Understanding that the CDS spread is essentially the cost of insurance against default helps clarify its role in financial markets, particularly in credit risk management and investment strategies involving credit derivatives. It enables investors to gauge the level of risk associated with a particular bond or entity, influencing their investment decisions accordingly.