Credit Default Swap
Credit Default Swaps (CDS) are financial derivatives which transfer the risk of default to another party in exchange for fixed payments.
CDS is a form of insurance for issuers of loans.
A “credit default” is a default or inability to pay back a loan.
The “swapping” takes place when an investor “swaps” their risk of net getting paid back with another investor or insurance company.
How Do Credit Default Swaps Work?
To swap their risk of default, the buyer of a CDS makes periodic payments to the seller until the credit maturity date.
In the agreement, the seller commits that, if the loan issued by the buyer of the CDS defaults, the seller will pay the buyer all premiums and interest that would’ve been paid up to the date of maturity.
Just like an insurance policy, a CDS allows purchasers to buy protection against a default on their outstanding loans.
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