A Credit
Default Swap (CDS) is now a days one of the most widely traded form of credit derivative, it's one more example of Hedging tool. It is
similar to an insurance contract, providing the buyer need to pay to buy (insurance) protection from another party for losses that may occur as a result
of the ( loan, sovereign debt, company bond ) default, bankruptcy or credit rating downgrades.
The
"buyer" of protection pays a fixed fee or premium for the protection,
and in return, the "seller" of protection promises to make a payment
equal to the losses incurred upon the occurrence of credit events
The
"buyer" of protection = XXX Bank
The
"seller" of protection = YYY Insurance Company
Suppose
Bank XXX buys corporate bonds issued by a IT Company ZZZ.
In order
to hedge the default risk of ZZZ, Bank XXX buys a CDS from Insurance Company ZZZ.
XXX pays a
periodic fee to ZZZ, in exchange for a credit default protection
In
return, ZZZ agrees to pay XXX a set amount if a credit default event occurs.
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