What is a credit default swap?

A **credit default swap (CDS)** is a financial derivative that functions like an insurance contract against the risk of a borrower defaulting on their debt. Essentially, it allows one party to transfer the credit risk of a particular loan or bond to another party. Here's how it works: Suppose an investor holds a bond issued by a company or government and wants to protect against the possibility that the issuer might fail to repay the bond (a default). The investor can enter into a CDS contract with a counterparty (often a financial institution) who agrees to compensate the investor if a default or other credit event occurs. In exchange for this protection, the investor pays periodic premiums (like insurance premiums) to the seller of the CDS. If the borrower does **not** default, the seller collects these premiums as profit. But if the borrower **does** default or experiences a credit event defined in the contract (such as restructuring or bankruptcy), the seller pays the buyer an agreed-upon amount, usually the face value of the debt minus its recovery value. This arrangement helps investors manage credit risk without necessarily selling the underlying bond. CDS contracts played a significant role during the 2008 financial crisis, as they were widely used to speculate on credit risk and sometimes amplified market volatility. Today, they remain important tools for hedging credit exposure and for price discovery in credit markets. However, because they are complex and involve counterparty risk (the risk that the seller might not fulfill their payment), they are generally traded by sophisticated institutional investors rather than typical retail investors.