Credit Default Swap (CDS)
A Credit Default Swap (CDS) is a financial derivative that functions like an insurance policy against the default of a borrower. One party (the buyer) pays periodic premiums to another party (the seller) in exchange for protection against a credit event, such as default or bankruptcy, related to a specific bond or loan. If the borrower defaults, the seller compensates the buyer for the loss. CDSs are commonly used by investors to hedge credit risk or speculate on the creditworthiness of issuers.
Example
An investor holding corporate bonds may purchase a CDS to hedge against the risk of the company defaulting on its debt. If the company defaults, the CDS seller pays the investor for the loss.
Key points
• A CDS is a financial contract that provides protection against a borrower’s default.
• The buyer pays premiums, and the seller compensates the buyer if a credit event occurs.
• CDSs are used to hedge credit risk or speculate on a company’s creditworthiness.
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