What is meant by 'credit default swap'?

A credit default swap (CDS) is fundamentally an agreement between two parties where one party agrees to pay the other in the event of a default by a borrower on a specified debt obligation. This mechanism allows the party buying the CDS to transfer the credit risk associated with that borrower to the seller of the swap. Essentially, the buyer of the CDS pays a premium to the seller in exchange for the promise of compensation should a default occur. This agreement can enhance the risk management capabilities of investors or financial institutions, as they can protect themselves from potential losses due to credit events, such as defaults or bankruptcies.

The other options do not accurately capture the essence of a credit default swap. For instance, avoiding interest payments does not align with the purpose of a CDS, which is more about managing credit risk than circumventing financial obligations. Reducing operational risk pertains to risks that arise from internal processes or systems, which is unrelated to credit default swaps. Lastly, increasing liquidity in a portfolio typically involves strategies like buying and selling financial assets to optimize cash flow, and while CDS can be bought or sold, their primary function is credit risk transfer rather than liquidity enhancement.