What is credit default swap?

A credit default swap (CDS) can be used by investors as insurance against specific risks.

Typically investors use credit default swaps to transfer the non-payment risk (default risk), associated with an investment to a third party, such as an insurance company. It assumes the risk for a fee, and pays out to the investor should the loan default.

For a credit default swap to work there must be a minimum of three parties; the investor, the issuer and the credit default swap seller.

Where have you heard about credit default swap?

A credit default swap is one of the most popular types of credit derivative, popularised by JPMorgan in order to allow banks to transfer their credit exposure. While insulating investors from the risk of non-payment, credit default swap can also help issuers guarantee their credit.

What you need to know about credit default swap.

Credit default swap is regarded as a useful portfolio management tool for investors as it allows them to limit their risk. Where an issuer doesn’t default, an investor may lose some of their money, however they would stand to lose much more without a credit default swap in place.

While credit default swaps appear similar to insurance products, due to the premiums paid in exchange for a payout, they differ slightly. For example, with a default credit swap an investor doesn’t need to suffer a loss directly to receive a payout. And, if a payout occurs, all parties receive an equal sum.