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What is a credit default swap?

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โˆ™ 2009-05-16 15:07:38

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I would recommend reading the article "The Price of Greed" in the Sept 29 issue of Time magazine. CDS's are derivatives, sold by AIG, designed to protect investors from failures of other companies. Time calls them "pixie-dust" securities that supposedly offer insurance against a company defaulting on its obligations. They are collaterized, which is where AIG got into trouble when their credit rating was downgraded. The required additional collaterial was nowhere to be found. A CDS is essentially an insurance policy for credit derivatives. It's not technically insurance for quite a few reasons, chief among them being that, as derivatives, the sellers aren't regulated nor are they required to maintain reserves enabling them to pay off the buyers if the underlying securities default, and the buyer of a CDS doesn't need to own the derivative he's insuring. These are the "naked CDS." I have written extensively on the evil that is the naked CDS, usually comparing it to naked fire insurance. If they sold that product, very little would prevent the naked fire insurance holder from going over to his neighbor's house and setting it on fire so he could collect. AIG was the leader in the naked CDS and a very large player in clothed CDS, In ten years, when the dust has settled, we'll all look back and think, "who thought THIS was a good idea?" Until then the naked CDS stands as prima facie evidence that deregulating the derivatives market was a really stupid idea.

A credit default swap (CDS) is a credit derivative contract between two counter parties, whereby the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or credit event in respect of a third party or reference entity.

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or on the occurrence of a specified credit event (for example bankruptcy). Credit Default Swaps can be bought by any investor; it is not necessary for the buyer to own the underlying credit instrument.

A CDS is like a Health insurance policy that we may take to cover up for the cash requirements if we get any health problems. We pay a premium to the insurance company and if we get any health problems, the insurer would pay for the medical treatment. Here are the differences between credit default swaps and "traditional" insurance, according to Wikipedia: * the seller need not be a regulated entity; * the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements; * insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets; * in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract; * Hedge Accounting may not be available under US GAAP unless the requirements of FAS 133 are met; in practice this rarely happens; * The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.[2][3][4] By contrast, to purchase insurance the insured is generally expected to have an insurable interest such as owning a debt. The last one is the most important here. Think of fire insurance. They don't allow people to purchase fire insurance on other people's buildings for the obvious reason: people would insure the worst firetraps in town, then go around burning them down to collect the insurance settlements. OTOH, you can buy CDS contracts on derivatives you don't own and never will--essentially betting that the underlying derivative is going to fail. Here's an example: You are the CEO of the biggest factory in the state, and you're getting ready to move your operations to Vietnam--which is going to put a few thousand people out of work. You could use your contacts in business to find out where your employees' mortgages are tranched (read up on structured financing), and buy naked CDS on those tranches. If you're the only one in town that pays decently, a lot of your employees are going to lose their homes, and you'll be in fat city when it happens. Right now you should be thinking, my but that would be a vicious thing to do. Yes it would, but so would closing your factory because you can get kitchen utensils made in China for two percent less than you're making them in the US, and that happens all the damn time.

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โˆ™ 2009-05-16 15:07:38
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Related questions

What kind of agreement is a credit default swap?

The agreement for a credit default swap is a document that states the buyer will reimburse the holder in the event of a loan default or other credit event. This is essentially insurance against someone not paying you what you are owed.


What is the meaning of the term Credit Mutual?

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.


What is the minimum amount for a party to enter into a credit default swap?

There is no "minimum amount" required for a party to enter into a credit default swap. The market for CDS products varies and terms are set by both parties agreeing to enter into the transaction.


Who invented the credit default swap?

Credit default swaps were invented with collateralised debt obligations in 1995 by Ms. Blythe Masters, a 34-year Cambridge graduate who was then the head of JP Morgan's Global Credit Derivatives group.


What has the author Sergio Mayordomo written?

Sergio Mayordomo has written: 'Are all credit default swap databases equal?'


When would a credit default swap be used?

This method would be used when speculating on how credit worthy the reference is. This term is also referred to as a credit derivative contract, and is used among brokers.


What is mortgage default swap?

I think what you are referring to is basically a credit default swap. This is a kind of insurance that the lender of the loan or the mortgage can purchase in order to ensure that the re-payment on the loan will be made in the event that the borrower defaults on the payment. This protects the back and spreads the risk.


How are journal entries made for credit default swaps?

Everything has to be entered. You can write down the number with a little notation to show that a swap has been made.


How exactly does a credit default swap work?

"Most of the time, they take two people's bad credit and subtract both debts by the lower number. They can, however, make you sign a contract. SO WATCH out and read the contracts."


What is a CDS?

The acronym CDS is a credit default swap. A financial term for a derivative contract whereby one party buys protection against the default of a reference credit and the other counterpary sells the protection, i.e. agrees to receive periodic payments in exchange for providing insurance against the default of an obligor.The acronym CDs is the plural form for compact disk and certificate of deposit.


What is naked CDS - Credit Default Swap?

A naked CDS is the purchase of CDS's without an investment in the underlying asset. Essentially buying insurance without the asset. Usually linked with speculation in the creditworthiness of the company. Speculators trade the likelihood a company will default on its payments.


If you default on your pay day loan will that affect your credit?

Yes, if you default on any loan it will affect your credit rating negatively.

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