how credit default swaps cdss work
a credit default swap is a derivative contract that transfers the credit exposure of fixed income products it may involve bonds or forms of securitized debt derivatives of loans sold to investors for example suppose a company sells a bond with a 100 face value and a 10 year maturity to an investor the company might agree to pay back the 100 at the end of the 10 year period with regular interest payments throughout the bond s life because the debt issuer cannot guarantee that it will be able to repay the premium the investor assumes the risk the debt buyer can purchase a cds to transfer the risk to another investor who agrees to pay them in the event the debt issuer defaults on its obligation 1debt securities often have longer terms to maturity making it harder for investors to estimate the investment risk for instance a mortgage can have terms of 30 years there is no way to tell whether the borrower will be able to continue making payments that long that s why these contracts are a popular way to manage risk the cds buyer pays the cds seller until the contract s maturity date in return the cds seller agrees that it will pay the cds buyer the security s value as well as all interest payments that would have been paid between that time and the maturity date if there is a credit event 1credit default swaps and credit eventsthe credit event is a trigger that causes the cds buyer to settle the contract credit events are agreed upon when the cds is purchased and are part of the contract the majority of single name cdss are traded with the following credit events as triggers terms of a cds