What is a "credit default swap"?

A credit default swap (CDS) is fundamentally a financial derivative that allows one party to transfer the risk of credit default to another party. This mechanism serves to hedge against the possibility that a borrower will fail to make required payments, effectively providing protection to the buyer of the swap. The buyer pays periodic premiums to the seller of the CDS, and in return, the seller agrees to compensate the buyer if a specified credit event occurs, such as a default by the underlying borrower.

The significance of credit default swaps lies in their role in enabling investors to manage and mitigate credit risk, which is a crucial aspect of financial markets. They can be used by both institutional and individual investors to either speculate on the creditworthiness of entities or to protect existing investments from potential defaults.

While other options generally pertain to different financial instruments or concepts, this distinction emphasizes the unique purpose of CDS in addressing credit risk specifically, distinguishing it from insurance policies, stock investments, or bond guarantees, which have different functions in the financial ecosystem.