Question

Credit default swaps (CDSs) are agreements to swap securities at some specified event. What are CDSs?

a) Insurance policies
b) Investments
c) Contracts
d) All of the above

Answer 1

A credit default swap (CDS) is a contract that acts like an insurance policy, providing protection against the default of a particular financial asset. It is not an investment or a straightforward insurance policy but a derivative, tied to the performance of other assets.

Step-by-step explanation:

Credit Default Swaps (CDSs)

Credit default swaps (CDSs) are complex financial instruments that can be categorized as contracts. They function similarly to an insurance policy because they provide the buyer of the swap with protection against the default of a particular financial asset. In essence, if the underlying asset defaults, the seller of the CDS compensates the buyer. This mechanism was a key component in the global financial crisis and contributed to the Great Recession beginning in 2007.

CDSs are not traditional investments like stocks or bonds, nor are they straightforward insurance policies since they can be bought and sold by parties who do not own the underlying asset. They are, instead, a form of derivative because their value is derived from the performance or failure of other financial assets, such as collateralized mortgage obligations (CMOs).