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Credit Default Swaps

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  • 30-08-2008 3:18pm
    #1
    Drag00n79
    Registered Users Posts: 2,746 ✭✭✭


    I was just reading an Australian article on the credit crunch today and it says credit default swaps were the most popular type of investments behind the crunch. Can anybody explain to me in *very* layman's terms how they operate? I tried googling but to be honest some of it went over my head. In particular, I can't see what benefit each party gets from such a scheme.


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    #2
    Thomas_S_Hunterson
    Closed Accounts Posts: 6,151 ✭✭✭Thomas_S_Hunterson


    It's like insurance against a bad debt (although not technically insurance).

    Basically one party pays another a fee to cover the risk of someone defaulting on debt. The interesting thing is that you don't have to have lent any money to buy into a CDS. You can 'cover' yourself against an arbitrary amount of non-existant debt and get a big payout if the underlying borrower goes belly up.

    It's a way for banks to throw around risk. The seller of the protection gets their fee and the other party is either protected against default, or set to make a few bob in the event of default.


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    #3
    Économiste Monétaire
    Closed Accounts Posts: 2,208 ✭✭✭Économiste Monétaire


    Ahh the credit default swap (CDS). The basic idea is: assume a bank has made a loan to a client, but the bank now wants to sell the risk on its loan (this could be due to a number of reasons, most likely it is overexposed to the client, industry or country). The bank is under concentration risk which is the opposite to diversification (don’t put all your eggs in one basket). The bank will find someone who wants the risk (an investor), maybe because they are underexposed to the area, and want to diversify into the market. The two parties then enter into a credit default swap.

    The bank, who originally made the loan to the client, pays an investor fee which is the margin on the loan. In return for the investor fee the investor indemnifies the bank against losses if the company defaults and/or goes bankrupt. The payment then compensates the bank on the loss. In simple terms think of it as insurance against default.

    But, it isn't insurance in name - you just don't call it that because only licensed insurers can sell insurance :pac:

    Edit: Trust the actuary to smell a question about risk a mile away :rolleyes:


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