A credit default swap (CDS) is a type of credit derivative instrument that protects a buyer from default and other risks associated with debt instruments held by him.
Until the credit maturity date, the buyer of a CDS has to pay to the seller a premium on a regular basis.
In exchange, the seller guarantees that, in the event of a default by the debt issuer, he or she will reimburse the buyer, the principal and interest due on the debt instrument until the date of maturity.
A credit default swap is similar to an insurance contract where the buyer transfers the risks associated with a debt instrument, in exchange for a premium, to a third party.
Credit default swaps are a popular tool to manage (hedge) credit risks associated with debt instruments.
Credit default swaps are over-the-counter credit instruments.
The value of a CDS is linked to the underlying debt instrument. A decline in the creditworthiness of the debt issuer adversely impacts the price of the CDS instrument. This is because the seller of the CDS must compensate the buyer for any financial loss he suffers as a result of any default by the debt issuer.