Credit Default Swap (CDS) contracts have become increasingly important in the global credit market.
These derivatives offer investors a flexible solution to manage credit risk associated with various financial assets, from corporate bonds to mortgage-backed securities.
A Credit Default Swap (CDS) is a derivative product that allows an investor to exchange or offset their credit risk with that of another investor.
In a typical CDS agreement, the “protection buyer” pays a periodic premium to the “protection seller” in exchange for the latter’s promise to reimburse the buyer in the event of a credit event, such as the default of a reference entity.
In essence, Credit Default Swaps act as insurance for the creditor party of an underlying contract.
While designed for protection, the reckless use of CDS in the past played a significant role in the subprime mortgage crisis in America.
The mechanism of a CDS can be outlined as follows:
This structure allows investors to transfer credit risk without necessarily holding the underlying asset, providing them with greater flexibility in portfolio management.
The CDS market can be divided into three main sectors:
Regardless of the type, CDS contracts can have maturities ranging from 1 to 10 years, with the five-year contract being the most actively traded segment.
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