Credit Default Swap (CDS)

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What it is:
A credit default swap (CDS) protects lenders in the event of default on the part of the borrower by
transferring the associated risk in return for periodic income payments.
How it works/Example:
In a credit default swap (CDS), two counterparties exchange the risk of default associated with
a loan(e.g. a bond or other fixed-income security) for periodic income payments throughout the life of
the loan. In the event that the borrowing party (the issuer) does default, the insuring counterparty
agrees to pay the lender (bondholder) the par value in addition to lost interest. The bondholder (lender)
seeks protection against the risk that the issuing company (borrower) might default. The insuring
counterparty hedges that the issuing company will not default, and will ultimately profit from the income
payments without having to compensate the bondholder for the par value and remaining interest.
To illustrate, suppose Bob holds a 10-year bond issued by company XYZ with a par value of $1,000
and a coupon interest amount of $100 each year. Fearful that XYZ will default on its bond obligations,
Bob enters into a CDS with Steve and agrees to pay him income payments of $20 (similar to an
insurance premium) each year commensurate with the annual interest payments on the bond. In return,
Steve agrees to pay Bob the $1,000 par value of the bond in addition to any remaining interest on the
bond ($100 multiplied by the number of years remaining). If XYZ fulfills its obligation on the bond
through maturity after 10 years, Steve will make a profit on the annual $20 payments.
Why it Matters:
A credit default swap protects bondholders and lenders against the risk that the borrower will default.
The lender's insuring counterparty takes on this risk in return for income payments. In this respect it is
important for the insuring counterparty to fully assess the swap's risk/return feature to ensure it is
receiving fair compensation vis--vis the level of risk.
Definition of 'Credit Linked Note - CLN'

A security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors.

CLNs are created through a Special Purpose Company (SPC), or trust, which is collateralized with AAA-rated securities. Investors buy securities from a
trust that pays a fixed or floating coupon during the life of the note. At maturity, the investors receive par unless the referenced credit defaults or
declares bankruptcy, in which case they receive an amount equal to the recovery rate. The trust enters into a default swap with a deal arranger. In
case of default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee which is passed on to the investors in the form of a
higher yield on the notes.
Investopedia explains 'Credit Linked Note - CLN'

Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk,
and gives investors a higher yield on the note for accepting exposure to a specified credit event.