What Is a Credit Default Swap (CDS) and How Does It Relate to Counterparty Risk?

A Credit Default Swap (CDS) is a financial derivative that allows an investor to "swap" or offset their credit risk with that of another investor. The buyer of the CDS makes periodic payments to the seller and, in return, receives a payoff if the underlying reference entity defaults.

The CDS itself introduces counterparty risk because the protection buyer is exposed to the risk that the seller of the CDS might default on their payment obligation.