A credit default swap (CDS) is a financial contract that allows an investor to protect against the risk of default on a loan or bond. CDSs are typically used by investors who are concerned about the creditworthiness of a particular borrower, such as a corporation or a country. When an investor buys a CDS, they are essentially paying an insurance premium to the seller of the CDS in exchange for the right to receive a payout if the borrower defaults on their loan or bond. The payout from a CDS is typically equal to the face value of the loan or bond, minus any recovery value that the investor is able to obtain from the bankruptcy proceedings.
CDSs can be a valuable tool for investors who are looking to manage their risk exposure. However, it is important to understand the risks associated with CDSs before investing in them. One of the biggest risks is that the seller of the CDS may itself default on its obligation to make a payout. Another risk is that the CDS may not provide full protection against all types of default. For example, a CDS may not cover defaults that are caused by fraud or other illegal activities. Despite these risks, CDSs can be a useful tool for investors who are looking to manage their risk exposure.