What do credit default swaps (CDS) allow investors to do?

Credit default swaps (CDS) are financial derivatives that allow investors to manage or transfer their credit risk associated with bonds or other debt obligations. In essence, when an investor purchases a CDS, they are entering into a contract with another party—typically a financial institution—that agrees to compensate the investor in the event of a default or credit event related to the underlying asset, such as a corporate bond. By using a CDS, investors can effectively "swap" their exposure to credit risk.

This mechanism provides investors with a way to either hedge against potential losses on their investment if they believe a borrower may default or to speculate on the creditworthiness of the borrower. If the credit quality of the borrower deteriorates, the value of the CDS contract increases, allowing the investor to profit from their bet against the creditworthiness of the borrower.

The other options do not align with the primary purpose of credit default swaps. For instance, reducing overall taxes relates to tax strategies rather than credit risk management. Investing in government bonds is a separate investment decision that does not involve a CDS, and short selling investment portfolios involves different strategies entirely, focusing on market movements rather than credit risk. Through this mechanism, credit default swaps serve as a crucial tool for managing and transferring risks in the financial