A credit default swap (CDS) is an agreement between two parties which are protection seller and protection buyer where the buyer of the CDS makes a series of payments to the seller and in return, receives the amount when the issuers defaults on its pre-agreed payment. In CDS, the credit risk of the issuer is transferred from investor or protection buyer to the protection seller.
CDS is based on the credit risk of a third party which is called the reference entity. The protection buyer will pay periodic payments to the protection seller just line insurance premium in return for a payment by the seller in case of a credit event. The buyer transfers the risk to the seller while the seller earns profit from premium.
Since the reference entity is not a party to agreement between the protection buyer and seller, the protection seller has no right to sue the reference entity for recovery of its loss.
Example in the above diagram:
A has invested in the debt issued by C where it feels that C can default on its payment of principal and coupon amount. That’s why A (Protection Buyer) wants to transfer some of its risk if C defaults on its payment and buys a CDS contract from B (Protection Seller). As a part of the agreement, A will make regular periodic payments to B. If C defaults, A will receive a onetime payment from B and the CDS contract is terminated. If there is no credit event, B receives the periodic fee from the A.
In CDS, both the counterparties experience certain amount of risk depending on the terms and conditions of the contract. Such risk is called Counterparty risk and it is different for both the counterparties.
If A and B enter into a CDS contract, then A is a counterparty for B and B is a counterparty to A. The risk of counterparty A will depend upon the ability of B to repay and vice versa. In CDS, protection buyer experience more counterparty risk as compared to protection seller.