What is the purpose of a credit default swap?

What is the purpose of a credit default swap?

• A. To insure against market volatility
• B. To allow investors to transfer credit risk
• C. To secure higher interest rates
• D. To increase liquidity of assets

Answer: (B)

The purpose of a credit default swap (CDS) is to allow investors to transfer credit risk. In this financial derivative, one party pays a periodic fee to another party in exchange for protection against the default of a borrower or a bond. If the borrower defaults, the protection seller compensates the protection buyer, which helps the latter to mitigate potential losses resulting from that default. Investors use credit default swaps as a way to manage their exposure to credit risk associated with debt instruments. This transfer of risk can create a more diversified investment portfolio because investors can hedge against the potential default of specific borrowers while still participating in the credit markets. The other options do not accurately capture the primary function of a CDS. For instance, credit default swaps do not directly insure against market volatility or secure higher interest rates; their main role is specifically related to the management of credit risk. Additionally, while they might indirectly influence liquidity in certain scenarios, increasing liquidity of assets is not the fundamental purpose of a CDS.

The purpose of a credit default swap (CDS) is to allow investors to transfer credit risk. In this financial derivative, one party pays a periodic fee to another party in exchange for protection against the default of a borrower or a bond. If the borrower defaults, the protection seller compensates the protection buyer, which helps the latter to mitigate potential losses resulting from that default.

Investors use credit default swaps as a way to manage their exposure to credit risk associated with debt instruments. This transfer of risk can create a more diversified investment portfolio because investors can hedge against the potential default of specific borrowers while still participating in the credit markets.

The other options do not accurately capture the primary function of a CDS. For instance, credit default swaps do not directly insure against market volatility or secure higher interest rates; their main role is specifically related to the management of credit risk. Additionally, while they might indirectly influence liquidity in certain scenarios, increasing liquidity of assets is not the fundamental purpose of a CDS.