Credit Default Swap (CDS)

When we buy a bond, we take multiple risks (and remember, risk is what we are paid for). One of the risks we’re taking is credit risk, which is the risk that the other party cannot meet their financial obligations. For example, consider a corporation that has issued a bond and must pay interest on the coupon dates. The credit risk is the risk that this corporation cannot make the interest payment, or when the bond is due, cannot make the lump sum payment.

In order to be protected against possible defaults by the other party, a CDS is purchased, which is in essence an insurance policy. The buyer of the CDS is seeking protection (doesn’t want risk) and the seller of the CDS is assuming risk.