What is a credit default swap?
A credit default swap is a type of credit derivative that protects the holder from a loss in the event that the issuer defaults on their debt obligations. The receiver of the protection pays periodic premiums to the provider, and in return, they receive a payout if the issuer defaults.
Credit default swaps can be used to hedge against losses on bonds and other debt instruments, or they can be traded as a speculative bet on the likelihood of default.
Cambridge dictionary
a type of credit derivative in which the buyer pays the seller for the right to get money back if a particular loan, bond, etc. is not paid back.
Wikipedia
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
In the event of default, the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan or its market value in cash. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called “naked” CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction. The payment received is often substantially less than the face value of the loan.
What credit default swaps are used for?
When used to hedge, credit default swaps are typically paired with the underlying bond or security. For example, if an investor owns a bond that is issued by Company A, they might purchase a credit default swap that protects against a loss in the event that Company A defaults on their debt.
Speculative traders use credit default swaps to bet on the likelihood of default without having to purchase the underlying bond. This can be done by buying or selling protection against a specific issuer, or by taking a position in an index of credit default swaps.
