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Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."
Bank A would extend a $1 million loan to the Steel Company.
At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.
If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.
Exhibit Bank A Institutional investors Steel Company $1 Million fixed or floating coupon,if defaults or declares bankruptcy the investors receive an amount equal to the recovery rate $1million 500b p Steel Company