1. # Suppose, I gave $ 10 million loan to A. This is my asset. If A will become defaulter, what will happen with my $ 10 million investment in the form of loan. It will become Zero. I am also noble personality and I can not quarrel with A. So, I contract with an insurance company and buy credit swap policy. Now, I am tension free. If my borrower will not repay my loan, my $ 10 million loan will be repaid by insurance company. So, like interest rate swap, credit default swap is exchange agreement between insurance company and lender. Insurance company takes the risk of loss due to loan defaulting. Lender will be responsible to pay the amount of CDS policy.
2. # Suppose, I sell this credit default swap (CDS) policy to B and B sells CDS policy to C. (By this way CDS will become a market product and speculators can deal in this for getting trading earning). Now C is buyer of policy and B is the seller of CDS policy. Borrower of $ 10 million loan will become reference entity. C ( Buyer) will pay of quarterly premium. Suppose A ( Borrower or referring entity) defaults on the loan. Now, it is duty of B ( Seller) to pay the par value of $ 10 million to C ( Buyer). By this C can get protection.
3. # Suppose, XL bank sells CDS to C for getting annual premium and covering loss of A company's bonds. In 4th year, A company declares that it has not capacity to pay the amount of bond. In same year, XL bank also defaults. At that time C will face loss of CDS contract.
4. # If you read the above three points deeply, you have understood about the credit default swap in real sense. Now, come and go to more deep of credit default swap with the help of following presentation. Credit Swap contract is done with good credit rating organisation like American International Group, Inc (AIG). AIG is largest seller of CDS financial product.It can easily cover risk of defaulting on loan by getting premium from lots of lenders whose borrowers are non-defaulter.