Pros and cons of a CDS
Pros of credit default swaps
Credit default swaps can act as insurance against a damaging market event which causes borrowers to default on their debt obligations. As a result, lenders who buy a CDS are more protected against default than if they did not buy the CDS.
Cons of credit default swaps
Credit default swaps require the buyer to pay a quarterly premium to insure themselves. Because of this, the lender should assess whether their exposure to risk is sufficient to justify buying the CDS in the first place.
In a particularly damaging unexpected market event – such as the 2008 financial crisis – credit default swap sellers could also be forced to default on their obligation to pay the buyer of the CDS. If this happens, the buyer of the CDS has no protection, and they will also often lose the premium for purchasing the CDS.