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Can someone explain in laymen terms what exactly are credit-default swaps? And how do hedge funds made a killing on them during the market crash in March? (I am assuming these are debts that parties cannot pay back and have to be auctioned/sold? How does it work?)

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A credit default swap is an insurance policy against the risk that a bond defaults-- that is, that a payment is not made.

Imagine you run a large pension fund. Among your holdings, you have $100 million in Walmart bonds. The risk that Walmart isn't going to make a payment on their bonds is extremely small but not zero. If that very unlikely event happened, though, your pension fund would take a major hit. To hedge against that, you'd buy a credit default swap-- you'd pay a small fee (likely an upfront fee and a periodic fee) to the seller of the swap. In return, if Walmart defaulted on their bonds, the seller would make the pension fund whole.

If the market consensus is that there is a 0.1% chance that Walmart defaults, the fair value of a credit default swap on $100 million in bonds would be $100,000 (I'm doing a whole lot of hand-waving here-- in reality you'd have lots of different bonds with different durations and different default risks, even if the bonds default, bondholders might recover some value in bankruptcy so you likely wouldn't use a full $100 million payout, and there will be spreads so you wouldn't buy at the theoretical fair value). If you're a hedge fund that believes that the real risk is much higher, you can buy a $100 million credit-default swap for $100,000 without owning any underlying bonds. If the market consensus changes to now believe that there is a 10% chance that Walmart defaults, that swap is now worth $10 million (again, handwavy math) and you've made 10,000% profit if you sell those swaps to the unhedged pension funds that are now in a panic that their bond holdings are going to tank.

I've seen various articles on the Ackman trade @BobBaeker referenced. They all talk about it being some sort of derivative but I've not seen any that specifically called it a credit default swap. My guess is that Ackman was trading a different but similar derivative. Credit default swaps entered the lexicon during the 2008 financial crisis so articles usually name them specifically if that's what was involved. Other derivatives aren't as commonly known so I'd guess that "credit protection on investment-grade and high-yield bond indexes" refers to something other than a credit default swap.

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    FWIW, in the article I linked, it mentioned that in 2007 Kyle Bass and his hedge fund "made a $4 billion profit by buying credit default swaps after the housing market crashed due to the ongoing US recession." Here's another article which states that Pershing (Ackman bought swaps.). They were probably interest rate swaps, not credit default swaps. Sep 13 '20 at 22:22
  • I wonder if you can insure against a swap writer defaulting ?? (For that matter, I mean, how much "margin" do you have to put up if you write a swap against $100m in bonds as in the example?!)
    – Fattie
    Sep 14 '20 at 17:37
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A credit default swap guarantees against against bond risk. Swaps work like insurance policies. It's insurance protection against an unlikely event. Think of it as a more complex, more leveraged put.

Bill Ackman turned a $27 million bet into $2.6 billion in a genius investment.

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  • So it's insurance against a Bond crash? Which would elevate THAT much to be comparable to that of PUTS? (p.s. yes that is the article that piqued my interest)
    – Steve237
    Sep 13 '20 at 4:03
  • just checked the 10yr yield went from 1.9% to a low of 0.54% in March crash. (was 3% just prior to 2019 also) So How does that translate to the big gain that he made for such a seemingly low percentage drop. I am sure there's hedging involved, but what are the details of that and how so?
    – Steve237
    Sep 13 '20 at 4:34
  • A credit default swap guarantees against against bond default risk. A CDS does not help you if a bond collapses due to, say, an interest rate spike.
    – D Stanley
    Sep 14 '20 at 13:40

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