What is a Credit Default Swap (CDS)?

by MB on September 16, 2008

Credit default swaps (CDS) have been in the news a lot lately. Most recently, they have been featured prominently in the trouble effecting American International Group (AIG).

What is a credit default swap? A credit default swap is a type of credit derivative, meaning its value is derived from the credit risk of a loan, bond, or other type of financial asset. A credit risk is the risk a lender takes that a debtor may not pay back a loan. In its simplest form a credit default swap allows a lender to pay another party for “insurance” against the default of a borrower. A buyer of a credit default swap receives protection against the default of a borrower, and a seller of the credit default swap guarantees that the lender will receive payment. Engaging in this transaction, effectively shifts the risk of default to the seller to the credit default swap, hence the name.

The market for credit default swaps is enormous, totaling $62.2 *trillion* at the end of last year, and has a huge effect on the world’s financial markets. 1 Take a little time and educate yourself on this subject. For further reading, I recommend you checkout the wikipedia article on credit default swaps.

  1. Derivatives and Dangerous Times

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