What is a Credit Default Swap (CDS)?

A Credit Default Swap (CDS) is a financial derivative contract that is used to transfer the credit exposure of fixed income products between parties. By definition, it is a bilateral over-the-counter (OTC) agreement where one party pays a premium to another party in exchange for a payoff if a third party defaults on its debt obligations. This effectively allows investors to manage and hedge against the risk of default, which is a key aspect of credit risk management.

In this context, the bilateral nature of the contract implies that it involves two parties agreeing on the terms and conditions of the swap, including the premium payment and the conditions that would trigger a default. This structure distinguishes CDSs from other financial instruments, as it specifically addresses credit risk, rather than equity or interest rate risk.

In contrast, other types of financial instruments mentioned, such as equity securities and fixed-income instruments, do not involve the same credit risk transfer mechanism inherent in a CDS. Equity securities represent ownership in companies and do not provide a direct hedge against defaults on debt. Fixed-income instruments typically involve debt obligations themselves, without the added layer of credit risk swapping seen in CDS contracts. Thus, the defining characteristic of a CDS as a tool focused on managing credit risk solidifies option B as the