What is Credit Default Swap?
Credit default swaps (CDSs) are financial derivatives that pay off when the issuer of a reference instrument defaults. This is a direct way to measure and transfer credit risk. These derivatives function like an insurance contract in which a buyer makes regular (quarterly) premium payments, and in return, they receive a settlement in the event of a default.
Example of Credit Default Swap
Let’s take an example of a Bank that is in the business of issuing advances to customers. If the Bank opts to go into a Credit Default Swap, the Bank will get into a contract with an institutional investor. The Bank will be paying a periodic premium to the Institutional Investor and getting the guarantee that if any of the borrowers get defaulted, the Bank will be getting the defaulted amounts.
Why is it essential to know Credit Default Swap?
For Risk Professionals, Credit Default Swap is a core product that should be understood. Credit Default Swap is the product that caused the Financial Crisis of 2008-2009 as most banks started opting for CDS which deteriorated the underwriting standards significantly