A Credit Default Swap is a contract that provides a hedge against credit default risk.
To guarantee against the non-payment of a loan, a Credit Default Swap can be purchased for a premium. The seller of the swap bears the risk of payment if a bond issuer defaults, or if there is a similarly threatening “credit event” which is agreed upon in the terms of the swap contract.
Generally, the buyer of a credit default swap will pay quarterly premiums for the protection, and the annualized premium is called the "spread," which may be a set percentage of the notional amount.
Many investors engage in speculation using credit default swaps, and will buy the swap without owning the bond it covers, which is known as a "naked credit default swap."
Credit default swaps are the most common form of credit derivative. Exposure to credit default swaps was a major factor in the financial troubles of large institutions in 2008.
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