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News: RBI kept FPI investment limits unchanged and fixed CDS sale limit at 5% of outstanding corporate bonds for 2026-27.
About Credit Default Swaps (CDS)
- Credit Default Swaps (CDS) is a financial derivative that allows investors to transfer or offset credit risk of a debt instrument.
- Key Components of a CDS:
- Parties: CDS involves a protection buyer and protection seller, where risk transfer takes place between them.
- Premium Payment: The buyer pays regular premiums similar to insurance payments to the seller.
- Compensation Mechanism: The seller agrees to pay the value and interest if a credit event like default or bankruptcy occurs.
- Underlying Reference: It is linked to a specific credit entity or credit instrument on which the risk of default is based.
- Uses of Credit Default Swaps:
- Risk Hedging: It is used to protect against default risk of a credit instrument.
- Speculation: It allows investors to bet on the creditworthiness of an entity.
- Arbitrage: It helps in exploiting price differences in credit markets.
- Risks:
- Counterparty Risk: The CDS seller may itself default, causing loss of protection.
- Premium Loss: The buyer may lose premiums paid if the seller fails.
