Chartered Financial Analyst (CFA) Practice Exam Level 2

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In a Credit Default Swap (CDS), who pays a premium to insure against a potential default?

The seller
The broker
The buyer
The lender

The correct answer is: The buyer

In a Credit Default Swap (CDS), the buyer is the party that pays a premium to the seller in exchange for protection against the risk of default on a reference entity's debt. The buyer essentially purchases insurance against the possibility that the issuer of the debt will not meet its obligations, such as failing to make interest payments or defaulting on the principal amount. This premium is typically structured as a regular payment, similar to an insurance policy, and is determined based on the perceived risk of default associated with the reference entity. The act of paying the premium allows the buyer to mitigate potential losses that could arise from holding the underlying credit exposure. If a default does occur, the CDS seller is obligated to compensate the buyer for the losses incurred, typically by paying the difference between the face value of the debt and its recovery value in the event of a default, thus fulfilling the protective role that the buyer sought in entering the CDS agreement.