Understanding Credit Default Swaps Characteristics

In the context of fixed income securities, credit derivatives are financial instruments that allow investors to manage their credit risk exposure. One of the most common forms of credit derivatives is the credit default swap (CDS). In a CDS, one party pays a periodic fee to another party in exchange for protection against the risk of default by a third-party borrower. Understanding the mechanics of credit derivatives, especially CDS, is crucial for assessing their implications in credit analysis and valuation.

Consider the following example: Investor A holds a bond issued by Company X and is concerned about the potential for default. To hedge this risk, Investor A enters into a credit default swap with Investor B. In this agreement, Investor A pays a fixed premium to Investor B, who in return agrees to compensate Investor A in the event that Company X defaults on its bond obligations.

Based on this scenario, which of the following statements accurately describes a characteristic of credit default swaps?