What is a credit default swap (CDS)?

A credit default swap (CDS) is indeed a financial derivative that offsets credit risk, making option C the correct choice. In essence, a CDS is a contract between two parties where one party pays a premium to the other in exchange for a guarantee against the default of a borrower, such as a corporation or government entity. If the borrower defaults, the protection buyer receives a payout from the protection seller, effectively transferring the credit risk associated with the underlying debt instrument.

This financial instrument is widely used by investors and financial institutions to manage and mitigate the risk of default on bonds and other credit obligations. By using CDS contracts, investors can hedge their exposure to credit risk, gain exposure to credit markets without owning the underlying asset, or speculate on credit events.

In contrast to a government bond, which represents a loan to a government entity, or a currency swap, which involves exchanging cash flows in different currencies, a CDS specifically addresses the risk of credit default. Similarly, a type of equity investment refers to ownership in a company rather than a derivative designed to protect against the risk of default. Thus, the nature and function of a CDS are clearly aligned with option C.