Which of the following best describes a 'credit default swap'?

Which of the following best describes a 'credit default swap'?

• A. A contract to insure against credit losses
• B. A mechanism to increase credit limits
• C. A tool for consumer loan applications
• D. A representation of an equity position

Answer: (A)

A credit default swap is best described as a contract to insure against credit losses. This financial derivative allows one party to transfer the credit risk of a third-party borrower to another party. Essentially, it functions as a form of insurance where the buyer of the swap pays periodic premiums to the seller, who in turn agrees to compensate the buyer in the event of a default by the underlying borrower, such as a corporation or government entity. Hence, it serves to protect investors from potential losses associated with credit defaults. Understanding this concept further involves recognizing the role of credit default swaps in financial markets, where they can provide a means for investors to hedge risk or speculate on the creditworthiness of entities. These contracts do not directly relate to increasing credit limits, consumer loan applications, or representing equity positions, which are aspects covered by various other financial instruments or agreements.

A credit default swap is best described as a contract to insure against credit losses. This financial derivative allows one party to transfer the credit risk of a third-party borrower to another party. Essentially, it functions as a form of insurance where the buyer of the swap pays periodic premiums to the seller, who in turn agrees to compensate the buyer in the event of a default by the underlying borrower, such as a corporation or government entity. Hence, it serves to protect investors from potential losses associated with credit defaults.

Understanding this concept further involves recognizing the role of credit default swaps in financial markets, where they can provide a means for investors to hedge risk or speculate on the creditworthiness of entities. These contracts do not directly relate to increasing credit limits, consumer loan applications, or representing equity positions, which are aspects covered by various other financial instruments or agreements.