What is a 'credit default swap' (CDS)?

What is a 'credit default swap' (CDS)?

• A. A stock option that provides investors a right to purchase shares
• B. A financial derivative that allows an investor to offset credit risk
• C. A type of savings account with higher interest rates
• D. A fixed income investment instrument

Answer: (B)

A credit default swap (CDS) is fundamentally a financial derivative used to manage and offset credit risk associated with debt instruments, such as bonds or loans. When an investor enters into a CDS agreement, they effectively purchase protection against the default of a borrower (typically a corporation or a government entity). In practice, the buyer of the CDS pays a regular premium to the seller, and in return, the seller agrees to compensate the buyer in the event that the referenced borrower defaults on its obligations. This mechanism provides a way for investors to hedge against potential losses resulting from defaults, allowing them to transfer the risk of default to another party. As such, a CDS can be seen as an insurance policy against the risk of a borrower failing to make debt payments. The other choices do not accurately describe a CDS. While a stock option provides rights related to equity shares, it does not pertain to credit risk. A savings account with higher interest rates involves deposits and is not related to derivatives or credit risk management. Lastly, while a fixed-income investment instrument refers to financial products that provide returns in the form of fixed periodic payments (like bonds), it does not encapsulate the essence of what a credit default swap is designed to do, nor does it address offset

A credit default swap (CDS) is fundamentally a financial derivative used to manage and offset credit risk associated with debt instruments, such as bonds or loans. When an investor enters into a CDS agreement, they effectively purchase protection against the default of a borrower (typically a corporation or a government entity).

In practice, the buyer of the CDS pays a regular premium to the seller, and in return, the seller agrees to compensate the buyer in the event that the referenced borrower defaults on its obligations. This mechanism provides a way for investors to hedge against potential losses resulting from defaults, allowing them to transfer the risk of default to another party. As such, a CDS can be seen as an insurance policy against the risk of a borrower failing to make debt payments.

The other choices do not accurately describe a CDS. While a stock option provides rights related to equity shares, it does not pertain to credit risk. A savings account with higher interest rates involves deposits and is not related to derivatives or credit risk management. Lastly, while a fixed-income investment instrument refers to financial products that provide returns in the form of fixed periodic payments (like bonds), it does not encapsulate the essence of what a credit default swap is designed to do, nor does it address offset