Credit Default Swaps (CDS) are instruments that enable holders of bonds and loans to hedge their credit risk by purchasing protection against a default by the issuer/borrower on such instruments, and to enable investors that do not hold the underlying debt instruments to make bets on the likelihood of such defaults.
The inherent conflict between sellers and buyers of CDS protection becomes more marked when a CDS protection buyer is either not exposed to the underlying debt, is “net-short” by virtue of holding a greater amount of CDS protection than its exposure to the underlying debt, or has acquired its position at a significant discount. In all of these instances, the CDS protection buyer stands to profit if a CDS credit event occurs.
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