Pricing is quoted in basis points a year on the notional. Protection on $10 million at 150 basis points costs $150,000 annually. If the reference entity defaults, settlement is usually through an auction that establishes a recovery price, and the protection seller pays the difference from par.
CDS lets an investor take a credit view without owning bonds, and lets a lender hedge exposure without selling a loan and damaging a client relationship. Index versions allow broad credit exposure in a single liquid contract.
What counts as a credit event is defined in documentation, not common sense, and disputes over restructurings and technical defaults have repeatedly been decided by industry committees. Read the definitions before relying on protection. See isda-master-agreement.
Related: isda-master-agreement, counterparty-risk, issuer-credit-risk, distressed-debt, central-counterparty, capital-structure-arbitrage