Credit Default Swaps are credit derivative contracts between two parties where the buyer makes periodic payments, such as a premium, over the maturity of a CDS to the seller. This is an exchange for a payoff if a third party defaults. A third party is usually a person who borrowed money from the banks to buy a house. By definition, default simply means the failure to fulfil an obligation.
– Buyer of a CDS:
Is usually betting against the market and wants the swaps to default. The buyer will be benefiting with the failure of the borrowers to make payments in order to achieve profit on those swaps.
When the market defaults, the value of the swaps increase.
In a More simple way:
Think of CDS as an insurance policy on mortgages in the event of non-payment or default.
It is like paying insurance on a house that is going to burn out. You are going to get a check after the house burns.
– Seller of a CDS:
Is betting that the market is not risky and the borrowers won’t default on their payments. Thus, they sell CDSs in order to collect premium.
The maximum profit of a CDS seller is the premium amount paid and the maximum profit of a buyer of a CDS is unlimited to the value appreciation of the CDS in case of any default.