what is a credit default swop?
Discussion
A Credit Default Swap, CDS, is in effect an insurance policy. Let's say I am a banker and I have lent a lot of money to Tesco. I might want to insure myself against the risk that Tesco will default on the loan. I could go to an investment bank and ask them to insure me against the danger that Tesco will default. The usual structure for a CDS is something along the following lines; the insurance will last for, say, five years, and during that time I will pay the investment bank a fixed fee every six months. If Tesco defaults, and fails to repay my loan in full, the investment bank will step in and make up the shortfall.
The deal is called a "credit default swap" because the two parties that strike the deal (in the example above, the banker and the investment banker) are agreeing to swap the risk of a default for the credit premium the market charges Tesco to borrow money.
These contracts are useful because they allow you to buy and sell credit risk, and this allows you to manage the risk you want to carry quickly and accurately.
ETA, here's a link to a wikipedia description that is accurate, but fails the plain Engish test quite badly:
http://en.wikipedia.org/wiki/Credit_default_swap
The deal is called a "credit default swap" because the two parties that strike the deal (in the example above, the banker and the investment banker) are agreeing to swap the risk of a default for the credit premium the market charges Tesco to borrow money.
These contracts are useful because they allow you to buy and sell credit risk, and this allows you to manage the risk you want to carry quickly and accurately.
ETA, here's a link to a wikipedia description that is accurate, but fails the plain Engish test quite badly:
http://en.wikipedia.org/wiki/Credit_default_swap
Edited by ATG on Monday 18th February 21:27
Yes, it's certainly one of the most commonly used credit derivatives, all of which are used to move credit risk around. If you are lending money (be it through buying a bond, directly lending cash, or whatever) you have two main risks; credit risk (i.e. borrower won't pay up, or will at least become seen as being less credit-worthy) and interest rate risk. Interest Rate Swaps, and other interest rate derivatives, are used for managing interest rate risk, and credit derivatives are used for credit risk management. At a guess I'd say that the use of Interest Rate Swaps emerged in the 1980s, getting huge towards the end of that decade. Credit Derivatives got going in the mid 1990s and have been huge for the last ten years or so. But well before that people had been creating and selling "asset backed securities", which allow borrowers and lenders to achieve a lot of the same goals as credit derivatives. For example, a credit card company could issue a bond and instead of them guaranteing to make the interest payments and eventually repay the loan, they'd say "if you buy the bond, you'll get paid interest and the redemption amount if and only if the people borrowing money with out credit cards pay us back first" ... i.e the bond's credit risk is linked to the people borrowing money on the credit cards, not the credit card company itself. That allows the credit card firm to unload credit risk it has accumulated from its customers, and allows someone else to gain that exposure instead. The other huge area of activity for ABSs is with mortgage lenders. A mortgage lender could take a chunk of its loan portfolio and use it to underwrite a bond, thereby getting a load of cash up front and shifting the mortgage risk off its own books.
If used sensibly these derivatives allow you to control your risk cheaply and efficiently. The perceived danger, and I have no idea how real it actualy is, is that the derivatives allow non-specialists to take on risk they don't really understand. In the past, if you wanted to take on credit card risk, you had to set up a credit card company, find customers, send them cardsin the post, etc, etc. Nowadays a trader or fund manager could pretty much just pick up the phone and take on a 10s of millions of dollars of credit card risk in a couple of minutes. Give them a few days and they could build up almost as much risk as you like. Dangerous tools in the hands of an eejit ... like these pillocks, for example: http://news.bbc.co.uk/1/hi/business/7214702.stm They used derivatives to create an offsetting risk to balance the risk they were expecting to take on through a deal which in fact never happened. God knows why they didn't wait until the deal had gone through before taking on the derivateive contracts, and it is even more of a mystery why they failed to offset the derivatives immediately the deal fell through. Instead they ran the position and ended up blowing several hundred million quid.
If used sensibly these derivatives allow you to control your risk cheaply and efficiently. The perceived danger, and I have no idea how real it actualy is, is that the derivatives allow non-specialists to take on risk they don't really understand. In the past, if you wanted to take on credit card risk, you had to set up a credit card company, find customers, send them cardsin the post, etc, etc. Nowadays a trader or fund manager could pretty much just pick up the phone and take on a 10s of millions of dollars of credit card risk in a couple of minutes. Give them a few days and they could build up almost as much risk as you like. Dangerous tools in the hands of an eejit ... like these pillocks, for example: http://news.bbc.co.uk/1/hi/business/7214702.stm They used derivatives to create an offsetting risk to balance the risk they were expecting to take on through a deal which in fact never happened. God knows why they didn't wait until the deal had gone through before taking on the derivateive contracts, and it is even more of a mystery why they failed to offset the derivatives immediately the deal fell through. Instead they ran the position and ended up blowing several hundred million quid.
My blog has a fair bit on CDS for insomnia sufferers
http://www.noelwatson.com/blog/CategoryView,catego...
http://www.noelwatson.com/blog/CategoryView,catego...
Mr Sump, As stated CDS are effectively insurance......no default...no payout, I don't see these as too much of a culprit to recent events.
You need to look into CDO's, collateralized debt obligations, the structure of these has caused most of the problems with respect to the credit crunch and writedowns against the balance sheets of major financial institutions.
Summary in clearer terms than I could write
http://en.wikipedia.org/wiki/Collateralized_debt_o...
You need to look into CDO's, collateralized debt obligations, the structure of these has caused most of the problems with respect to the credit crunch and writedowns against the balance sheets of major financial institutions.
Summary in clearer terms than I could write
http://en.wikipedia.org/wiki/Collateralized_debt_o...
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