Question

What is a credit default swap? What happens to the premium as the riskiness of the reference entity increases?

Answer 1

A CDS or Credit default swap is a type of derivative contracted in the market. It pays or offest a fixed amount when the borrower defaults. Using CDS many banks reduce their risk exposure to highly risky loans and makes their cashflow relatively stable.

As the riskiness of the reference entity or the loan increases, the premium of CDS will increase highly. ie there is always a risk return trade off for CDS. Premium is high because the person who is selling the task is taking a risky position and to offset this he demands a high premium.