A credit default swap is a type of credit derivative that provides the buyer with protection against the defaults. For example: if a lender feels that his/her loans to a borrower is at risk, he/she may use default swaps to minimize the risk.
It is just like the insurance policy in which we pay the premium timely. Here, a CDS seller acts like the insurance company and receives the premium periodically until the credit maturity date. According to Warren Buffet, CDS is also known as the Financial Weapon for Mass Destruction of 2008.It has a major roleplay in the Economic Recession of 2008.
There can be various bonds and securities that has a long term of maturity such as 20 yrs., 25 yrs, 30 yrs. etc. Due to this lengthy term of maturity, it is difficult for the investor to make the reliable estimates about the risk over the entire life of such bonds and securities. In a CDS, one party sells risk and the other party buys that risk. The seller of credit risk who also tends to own the underlying credit asset pays a periodic fee to the risk “buyer”. In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event)
Let us understand more about CDO with an example through this video and we would also love to discuss through https://camunchnepal.com/forums/
We can also know more about the financial crisis through https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308
