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CDSs can be used to create synthetic long and short positions in the reference entity.
In addition, CDSs can also be used in capital structure arbitrage.
However, there are also many differences, the most important being that an insurance contract provides an indemnity against the losses actually suffered by the policy holder on an asset in which it holds an insurable interest.
By contrast a CDS provides an equal payout to all holders, calculated using an agreed, market-wide method.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk.
However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs).
If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur: The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount.
For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying million worth of protection from AAA-Bank must pay the bank ,000.
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp.
The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection.
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Also, investors can buy and sell protection without owning debt of the reference entity.