Credit Default Swap (CDS)

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Definition of 'Credit Default Swap (CDS)'

A credit default swap (CDS) is a financial derivative contract between two parties, the buyer and the seller. The buyer of the CDS makes regular payments to the seller, and in return, the seller agrees to pay the buyer if a specific reference entity defaults on a debt obligation.

The reference entity is usually a company or government, and the debt obligation can be a bond, loan, or other type of debt instrument. The CDS buyer typically pays a premium of 1% to 5% of the notional amount of the CDS each year. The notional amount is the amount of the debt obligation that is covered by the CDS.

If the reference entity defaults on the debt obligation, the CDS seller is obligated to pay the buyer the difference between the face value of the debt obligation and the market value of the debt obligation. The market value of the debt obligation will typically be less than the face value if the reference entity is in default.

CDSs are often used by investors to hedge against the risk of default on a debt obligation. For example, an investor who owns a bond issued by a company that is at risk of default may buy a CDS on that company to protect against the loss of principal if the company defaults.

CDSs can also be used by speculators to bet on the likelihood of a default. For example, a speculator who believes that a company is likely to default may buy a CDS on that company in the hope of making a profit if the company does default.

CDSs are a complex financial instrument, and they can be risky. Investors should carefully consider the risks before entering into a CDS contract.

Here are some additional details about CDSs:

* CDSs are traded over-the-counter (OTC), which means that they are not traded on an exchange. This can make it difficult to get a fair price for a CDS.
* CDSs are not regulated by the Securities and Exchange Commission (SEC), which means that there is less oversight of the CDS market. This can increase the risk of fraud and abuse.
* CDSs can be used to create synthetic collateralized debt obligations (CDOs). CDOs are a type of structured investment product that can be very risky.

CDSs have been used in a variety of financial crises, including the 1998 Russian financial crisis and the 2008 global financial crisis. In the 2008 crisis, CDSs were used to bet on the default of subprime mortgages. This led to a surge in the price of CDSs, which in turn led to a decline in the value of the underlying subprime mortgages. This decline in value eventually led to the collapse of the subprime mortgage market and the ensuing financial crisis.

CDSs are a complex and risky financial instrument. Investors should carefully consider the risks before entering into a CDS contract.

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