What is a credit default swap and why might a client use one?

• A. A credit protection contract to hedge or speculate on credit risk of a reference entity.
• B. A forward contract to exchange principal on a reference entity.
• C. A currency swap between two parties.
• D. A loan agreement with a fixed repayment schedule.

Answer: (A)

A credit default swap is a derivative that transfers the credit risk of a chosen reference entity from the protection buyer to the protection seller. The buyer pays a regular premium, and if a credit event occurs (such as default or restructuring), the seller compensates the buyer for the loss on that reference obligation. This structure lets a client hedge against potential default risk or, alternatively, take a view on credit quality or gain synthetic exposure to credit without owning the underlying bond. It’s not a contract to exchange principal (that would be a forward-like instrument), not a currency swap, and not a loan agreement with fixed repayment.