when are cdss used 
as an insurance policy against a credit event on an underlying asset credit default swaps are used in several ways because swaps are traded they naturally have fluctuating market values that a cds trader can profit from investors buy and sell cdss from each other attempting to profit from the difference in prices 1a credit default swap by itself is a form of hedging a bank might purchase a cds to hedge against the risk of the borrower defaulting insurance companies pension funds and other securities holders can purchase cdss to hedge credit risk 7arbitrage generally involves purchasing a security in one market and selling it in another cdss can be used in arbitrage an investor can purchase a bond in one market then buy a cds on the same reference entity on the cds market 8a credit default swap is the most common form of credit derivative and may involve municipal bonds emerging market bonds mortgage backed securities mbs or corporate bonds 9the great recessioncdss played a key role in the credit crisis that eventually led to the great recession credit default swaps were issued by american international group aig bear sterns and lehman brothers to investors to protect against losses if the mortgages that were securitized into mortgage backed securities mbs defaulted mortgage backed securities are mortgages bundled into packages and then offered as shares the cdss were insurance against mortgage defaults so investors believed that they had completely reduced the risk of loss if the worst were to happen mortgages were given to nearly anyone that requested them because investment banks and real estate investors were generating huge returns as housing prices continued to climb cdss allowed investment banks to create synthetic collateralized debt obligation instruments which were bets on securitized mortgage prices 10many investment banks issued mbss cdss and cdos they were all betting on the performance of their own mortgage security derivatives when housing prices collapsed the big players could not pay all of their obligations because they owed each other and investors more money than they had 11because these investment banks were so entwined in global markets their insolvency caused global markets to waver and ushered in the financial crisis of 2007 2008 10mechanics of credit default swapsthe settlement process of credit default swaps involves several mechanisms aimed at determining the compensation owed to the protection buyer in the event of a credit event there are two main methods of settlement physical settlement and cash settlement in physical settlement the protection buyer receives the underlying debt securities from the protection seller upon the occurrence of a credit event the notional amount of the cds contract represents the face value of the underlying debt securities the protection buyer can then either hold the bonds as an investment or sell them in the secondary market in cash settlement the compensation owed to the protection buyer is determined based on the results of a credit event auction conducted by a designated auction administrator the auction aims to establish a market based price for the defaulted debt securities the final price is then used to calculate the cash settlement amount cash settlement is generally preferred in situations where there is limited liquidity in the underlying bond market advantages and disadvantages of cdsscredit default swaps offer several advantages for investors and institutions while credit default swaps offer the advantages above they also come with several downsides can reduce risk to lendersno underlying asset exposuresellers can spread riskcan create profitability opportunitiescan be customizedcan give lenders and investors a false sense of securitytraded over the counterseller inherits substantial riskmay be illiquid at timesmay be too complex for beginning investorscredit default swaps and counterparty riskas mentioned above counterpart risk represents the risk that the other party in the cds contract will default on its obligations in the context of cds counterparty risk arises because these contracts are typically traded over the counter between two parties without the oversight of a centralized exchange in a cds contract the protection buyer pays regular premiums to the protection seller in exchange for protection against credit events affecting a specified reference entity if a credit event occurs such as the default of the reference entity the protection seller is obligated to compensate the protection buyer for the losses incurred however if the protection seller defaults the protection buyer may not receive the compensation owed exposing them to the full credit risk associated with the reference entity therefore there is investment risk not necessarily with the product being held but with the entity in which it is associated with investors can employ various strategies to manage counterparty risk effectively they can and should conduct due diligence on potential counterparties to assess their financial health and creditworthiness they can diversify counterparty exposure by spreading trades across multiple counterparties they can use collateral agreements and credit support annexes to secure their positions and require counterparties to post collateral as security against potential losses 