Credit Default Swap (CDS):

A Credit Default Swap, or CDS, is a financial instrument that acts as an insurance policy against default on a debt, such as a loan or bond. It enables investors to sell or hedge their credit risk by swapping it with another investor. The seller of a CDS receives periodic payments from the buyer, while promising the buyer the difference between the par amount and the recovery amount in case the underlying borrower defaults.
Here’s the breakdown in greater detail:
Risk Transfer:
CDSs facilitate transferring the default risk of the lender (the buyer of the CDS) to a third party (the seller of the CDS).
Insurance Analogy:
A CDS can be compared to insurance coverage against a borrower’s default in repaying a loan or a bond.
Premium Payments:
The buyer pays a recurring premium (similar to an insurance premium) to the seller for coverage.
Default Compensation:
When the borrower is in default, the seller of the CDS is required to pay the buyer the loss, normally the full face amount of the debt instrument.
No Effect on Underlying Debt:
The CDS has no bearing on the initial debt contract between the lender and the borrower.
Speculation and Risk Management:
CDS can be employed for hedging (risk management) and speculation on the creditworthiness of an entity or a company.
Counterparty Risk:
There is counterparty risk for both the buyer and seller of a CDS, i.e., the risk that either counterparty will fail to fulfill their obligations.