A credit default swap (CDS) is a type of credit derivative that protects against the risk of default on a loan.

How CDSs Work:

• CDS Buyer: Pays a premium to the CDS seller.
• CDS Seller: Guarantees to pay the buyer if the loan borrower defaults.
• Reference Loan: The CDS is linked to a specific loan or group of loans.
• Credit Events: If the borrower defaults or experiences other specified credit events, the CDS seller pays the buyer.

Types of CDS:

• Protection CDS: Protects against the risk of default on a specific loan or group of loans.
• Credit Protection Fund CDS: Protects against losses in a credit protection fund.
• Index CDS: Protects against losses on an index of loans.

Uses of CDS:

• Risk Management: Hedge against the risk of loan default.
• Credit Protection: Obtain financial protection against potential losses.
• Speculation: Trade on credit market volatility.

Key Features:

• Credit Risk Transfer: CDSs allow investors to transfer credit risk to another party.
• Protection Against Default: They provide protection against losses due to default.
• Predictable Payouts: CDS payments are based on a fixed payout schedule.
• Market-traded: CDSs are traded on organized markets, allowing for liquidity.
• Credit Spread: The spread between the premium received and the cost of protection is the credit spread.

Advantages:

• Protection Against Default: CDSs provide a way to protect against loan default.
• Hedging: Can be used to hedge against credit risk.
• Liquidity: CDSs are traded on markets, providing liquidity.

Disadvantages:

• Cost: CDSs can be costly to purchase.
• Counterparty Risk: The CDS seller’s creditworthiness is important.
• Potential Losses: There is potential for losses if the borrower defaults.
• Market Volatility: CDS prices can fluctuate significantly due to market volatility.