What is a credit default swap?

A credit default swap is actually an instrument that resembles an insurance bond placed on a mortgage pool. It’s a credit derivative contract that ensures the buyer makes payments to the seller for the right to payoff if there is a default by the “borrower”. In essence you’re “Swaping” the default risk from the buyer of the security to the seller of the security.

If a default happens, usually the contract settles by delivering the underlying debt obligation from the buyer to the seller for payment by the seller of the face value or the seller pays the buyer the difference between the face value and the auction price of the underlying asset.