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What is a Credit default swap?
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.
Credit defulat swaps acts as insurance because it transfer the risk from buyer of CDS to seller of CDS in case of defualt. Seller of CDS pay face value of loan to buyer of CDS. It is actually non isurance product. CDS is not subjected to regulation governing traditional insurance product. Also, investors can buy and sell protection without owning debt and this is called 'Naked Credit Defualt Swaps' Most importantly, the seller is not required to maintain reserves to cover the protection sold