How Does a ‘Credit Default Swap’ (CDS) Work?

A Credit Default Swap (CDS) is a derivative contract where the buyer makes periodic payments (like insurance premiums) to the seller. In return, the seller agrees to pay the buyer a lump sum if a specified credit event (like a default or bankruptcy) occurs to a reference entity (e.g. a corporation or sovereign).

It is essentially an insurance contract against a borrower defaulting on their debt.