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As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp.
The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection.
If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated.
If the investor actually owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge.
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (usually the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event.
That is, the seller of the CDS insures the buyer against some reference loan defaulting.
The required collateral is agreed on by the parties when the CDS is first issued.
This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes.
This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses).
Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs having to perform under these contracts.
CDS contracts have obvious similarities with insurance, because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs.
CDSs can be used to create synthetic long and short positions in the reference entity.
In addition, CDSs can also be used in capital structure arbitrage.