Explain why the position of a buyer of a credit default swap is similar to the...

Explain why the position of a buyer of a credit default swap is similar to the position of someone who is long a risk-free bond and short a corporate bond.

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Credit default swap- It is a derivative contract that allows investor to swap his/her credit risk with other investor. It is used to transfer the credit risk between two or more parties. In this buyer of the swap pays to seller of the swap until the maturity date of contract.

Risk free bonds- These are the Government securities that do not have risk and pay a fixed amount of coupon/interest to bondholders. They repay the principal on time.

Corporate bonds- These bonds are issued by companies to raise the funds. They pay fixed amount of interest but they are risky bonds.

The position of a buyer of a credit default swap is similar to the position of someone who is long a risk-free bond and short a corporate bond- Credit default swap insures a corporate bond, issued by the company against default. CDS mitigates the risk by converting corporate bonds into risk free bonds. Buyer of a CDS chooses to exchange a corporate bond for a risk free bond that is why the buyer is long with a risk free bond and short with a corporate bond.

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