What is a credit default swap (CDS) and what does it hedge?

• A. A CDS is a credit derivative that pays out if a referenced default occurs; it hedges credit risk.
• B. A CDS is a currency option to hedge exchange risk.
• C. A CDS is an equity derivative to hedge stock risk.
• D. A CDS guarantees the creditworthiness of a borrower.

Answer: (A)

A credit default swap is a credit derivative that provides protection against the default of a reference entity. The buyer pays a regular premium to the seller, and if a credit event or default occurs on the referenced debt, the seller compensates the buyer for the loss, effectively transferring the credit risk from the bondholder or lender to the CDS seller. This is how it hedges credit risk: it insures against the borrower’s failure to meet obligations, offsetting potential losses on the underlying loan or bond. It’s not about currency risk or stock risk, and it doesn’t guarantee the borrower’s creditworthiness; it merely shifts the risk of default to another party.