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I hear a lot about CDSs (Credit Default Swap) and I not really know what they are. Can you please explain it to me? What are they good for?

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... they ain't good for nothin'! –  MrChrister Apr 6 '10 at 19:15
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Just kidding, I don't really understand them other than I think they are one of the whipping children of the current financial storm in the US and beyond. –  MrChrister Apr 6 '10 at 19:15
    
I've heard that CDFs have to do something with this crisis, but I am not sure in what ways and I would like to understand better. –  gyurisc Apr 7 '10 at 4:22
    
There were several good hour-long radio shows produced as joint projects between Radio Labs and Marketplace Money, which did an excellent job of explaining CDSs and collateralized loan traunches and the other derivitives whose abuse lead to the Great Recession (and how the banks deluded themselves into believing someone else was taking all the risk). Recommended listening. –  keshlam Jul 21 at 3:26

3 Answers 3

up vote 11 down vote accepted

From my understanding, a CDS is a financial product to buy protection against an event of "default" (default of payment).

Example: if General Motors owes me money $10,000,000 (because I own GM bonds for example) and I wish to protect myself against the event of GM not repaying the money they owe me (event called "credit default"), I pay FinancialCompany_X (the seller of the CDS) perhaps $250,000 per year against the promise that FinancialCompany_X will pay me in case GM is not paying me. This way I protected myself against that risk. FinancialCompany_X took the risk (against money).

A CDS is in fact an insurance. Except they don't call it an insurance which enabled the financial industry to avoid the regulation that applies to insurances.

There is a lot of infos here: http://en.wikipedia.org/wiki/Credit_default_swap

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@tucson Thanks for the answer –  gyurisc Apr 13 '10 at 6:15

A Credit Default Swap is a derivative, a financial contract with a value dependent upon another asset.

A CDS, in essence, is exactly what it sounds like a swap upon default.

The typical arrangement is that a holder of non-risk free credit enters into an arrangement with a counterparty to pay the counterparty a portion of the income received from the non-risk free credit in exchange for being able to force the counterparty to deliver risk free credit if the non-risk free credit defaults.

Banks use this mechanism to reduce the risk of the loans they produce while packaging them to be resold to investors. Banks will typically buy CDSes on mortgages and corporate bonds, paying part of the income from interest payments received, to have the right to force counterparties, typically hedge funds and insurance companies, to swap national Treasuries upon the event that the mortgages or corporates default. The banks receive less income yet are able to take on more inventory to sell to investors so that more loans can be made to borrowers, households and corporations.

Hedge funds typically take on more complex arrangements while insurance companies sell CDSes because they are usually overflowing with risk-free assets yet are starved for income.

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A Credit Default Swap (CDS) is a contract between two parties.

A useful analogy is insurance (but by no means exact). I pay a quarterly premium in order to insure myself against another event. In this case, it might be that I own some IBM Bonds. I am happy to own those bonds, and like the "coupon" that they pay me. But I am a little worried about IBM going bankrupt. So I can find someone willing to sell me a CDS. So long as I keep up my "premium" payments, if IBM goes into default on their bonds, I get a payout.

This analogy does break down at a couple of levels. Firstly there is no requirement that I have to own the IBM bond in the first place. I can in effect then "take a view" on IBM going into default by purchasing a CDS without owning the underlying asset.

Also in the real insurance world, there are various capital requirements that the companies have to adhere to, while CDS market, being essentially unregulated has none.

So to summarize, and while The Pedia has a pretty good article, they are good both to hedge your bet (i.e. protect your actual owned asset) or as a speculative tool to take a "view" on the likelihood of a company to go bankrupt.

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+1 for the detailed answer! Thanks –  gyurisc Apr 13 '10 at 6:14
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So what happens when the CDS defaults too? –  Pacerier Nov 27 '13 at 11:16

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