How would you define a credit default swap (CDS)?

A credit default swap (CDS) is best defined as a financial derivative that allows an investor to offset credit risk. In essence, it functions as a type of insurance against the default of a borrower. When an investor holds a debt instrument, they may be exposed to the risk that the issuer of that debt will default on their obligations. By entering into a CDS, the investor pays a premium to a counterparty, typically a financial institution, in exchange for protection against that default. If the borrower does default, the CDS guarantees that the protection seller will compensate the investor for the loss, effectively transferring the risk of default from the investor to the seller of the CDS.

This mechanism is crucial for institutional investors as it enables them to manage and mitigate credit risk associated with their portfolios. The use of CDS has become widespread in the financial markets because it provides a flexible way to hedge against credit losses without needing to sell underlying securities.