A credit default swap (CDS) is a financial derivative that allows an investor to "swap" or transfer the credit risk of a borrower to another party. Essentially, it is a contract between two parties where one party (the buyer of the CDS) pays a periodic fee to the other party (the seller of the CDS) in exchange for protection against the risk of default on a specified debt obligation, such as a bond or loan.
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The protection buyer pays a contractual premium in exchange for compensation upon a defined credit event of the reference entity. In a simple cash-settled contract of notional , a default loss with fractional recovery gives payment . Physical settlement instead exchanges an eligible defaulted obligation for par. Payments, accrued premium, maturity and eligible obligations depend on the contract. The protection buyer need not own the reference debt; the seller earns premium while taking the specified credit risk.