Credit Default Swap (CDS)

What Is a Credit Default Swap (CDS)?

A credit default swap (CDS) is a type of financial contract that works like insurance. It protects a lender or investor in case a borrower does not repay a loan. In a CDS, one party pays regular fees to another party, called the seller. In return, the seller promises to pay if the borrower defaults on the loan.

For example, suppose a bank lends money to a company. To reduce its risk, the bank buys a CDS from another firm. If the company fails to repay the loan, the CDS seller pays the bank the agreed amount. If the company pays back the loan on time, the seller keeps the fee and nothing else happens.

CDSs became widely known during the 2008 financial crisis. Many banks and investors used them to bet on or protect against mortgage loans. But because CDS contracts are not regulated like insurance, some firms took on too much risk. When large numbers of borrowers defaulted, many CDS sellers could not cover the losses, leading to a financial meltdown.

CDSs matter because they can help manage risk, but they can also create more risk if not handled carefully. Understanding how they work is important for anyone studying financial markets.

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Disclaimer: This post is for informational purposes only and does not constitute financial, legal, or investment advice. Please consult a qualified professional for guidance tailored to your situation.

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