What is a credit default swap (CDS)?

A credit default swap (CDS) is a financial derivative that serves as a contract between two parties, allowing them to transfer credit risk associated with a particular debt instrument, typically a bond or loan. In this arrangement, one party, the seller, agrees to compensate the other party, the buyer, in the event of a credit event, such as a default or bankruptcy, affecting the underlying asset. The buyer pays periodic premiums to the seller in exchange for this protection.

This mechanism plays a crucial role in financial markets by enabling investors to hedge against the possibility of credit events or to speculate on changes in creditworthiness of borrowers. By isolating and transferring credit risk, CDS can help investors manage their overall risk exposure within their portfolios.

The other options do not accurately describe a credit default swap. Selling equities between investors pertains to stock transactions, not credit risk management. Evaluating stock market trends refers to analysis methods that do not involve credit risk transfer. Managing foreign exchange risk is related to currency fluctuations, which is outside the scope of credit default swaps and their intended functionality.