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What is a Credit Default Swap?
Credit Default Swap is a kind of insurance. An insurance that is used to reduce the risk of debts. Insurance that allows me to invest in debts or which allows me to lent loan to a corporation that has poor ratings. That way, I can improve the investment’s ratings. Let’s take an example. Suppose I am a pension fund or mutual fund agency. I have a lot of money invested by investors. If I want to invest in debts or lent out a loan to a corporation that has lower credit ratings (i.e BB). Normally I am not allowed by the SEC to invest people’s money in poorly rated investments. Though, I can get the deal/investment insured with credit default swaps issued by the insurance agency (with a higher rating, AAA, or AA). And now my deal/investment got rating same as the CDS. I have to pay some % to insurance comapy out of interest that I would get from my lent-out loan or debts. If the corporation I have given the loan defaults, the insurance agency will have to pay me the notional capital (total loan capital).
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