Credit Default Swaps

A credit default swap (CDS) is similar to an insurance contract between two parties, a protection buyer (the insured) and a protection seller (insurer). The protection buyer seeks to insure an asset against a loss of principal. The protection seller agrees to provide insurance for a fee. The underlying asset, known as the reference obligation, could be a corporate bond or leveraged bank loan, sovereign debt (e.g., German Bunds), a basket of bonds or loans, a tranche from a residential mortgage–backed security (RMBS), or a tranche from a collateralized debt obligation (CDO). If the protection buyer owns the reference obligation, he is hedging (reducing) his credit risk. If the protection buyer does not own the reference obligation, he is speculating that the value of the ...