CDS, short for "Credit Default Swap," is a financial instrument used to hedge against the risk of default on a debt obligation or bond. It is a type of derivative contract in which two parties, known as the protection buyer and the protection seller, enter into an agreement. Under this agreement, the protection seller provides insurance to the protection buyer against the potential default of a specific debt issuer.
In a CDS, the protection buyer pays regular premium payments to the protection seller. In return, the protection seller agrees to compensate the protection buyer in case of default or any other credit event related to the referenced debt obligation. The specific terms and conditions of the CDS, including the duration and notional value, are outlined in the contract.
If a credit event occurs, such as a default or the restructuring of the debt obligation, the protection buyer can trigger the CDS and claim a payment from the protection seller. The payment is typically based on the difference between the face value of the debt obligation and its current market value or recovery value.
CDSs are commonly used by financial institutions, investors, and traders to manage their credit risk exposure and speculate on the creditworthiness of companies or governments. They provide a way to transfer credit risk between market participants without the need to buy or sell the underlying debt obligation. However, CDSs have also been criticized for contributing to the global financial crisis of 2008 and creating potential systemic risks in the financial system.
