Credit Default Swaps

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Permalink Reply by Emre Ozmen on March 12, 2010 at 1:36am

Im not too familiar on these but i would assume they are similar in structure to CDO's or what is also known as MBS's, split up in tranches. While in MBS's tranches represent the different level of mortgages and their defaults the tranches in these are time periods( to default), as you said the payment being default. The file should give you a visual on the concept

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• 605px-Cds_cashflows_svg.png, 13 KB

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Permalink Reply by Razni Razak on March 12, 2010 at 4:02am

Thanks Emre.

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Permalink Reply by David Smart on March 12, 2010 at 1:39pm

Hi Razni,

Credit Default Swaps are an indirect form of insurance…will explain that in a bit.

In my explanation, I assume that Ravni has purchased a $ 1 million five year AA rated bond for an entity Dubai World. And you have an option of purchasing a credit default swap (CDS) from AIG Financial Products.

Ideally, what a credit default swap is meant to do is to protect you from the loss in value of your bond that would be attributed to a ratings downgrade for Dubai World or a trigger event has arisen e.g. they decide to reschedule its principal and/or interest payments. I will refer to both scenarios as credit events

Now if you (as a rational investor) are worried about such events and you would like to protect your investment, you would decide to purchase a CDS from AIG Financial Products. They will require you to pay $ 100,000 upfront and $ 25,000 per annum. So, if there is no credit events, AIG Financial Products will be happy to recognise the payments (which are effectively premiums) as income. If you want more details of the actual prices for various companies, please go to the CMA Datavision website.

But whenever the credit events do occur, they might incur significant losses in their books. And if they are not financially sound, this would cause them to be out of business – which is exactly what happened to AIG.

In terms of regulation, the terms of a CDS ideally mirrors a typical insurance policy that you would take for your house or car. However, institutions such as AIG Financial Products stated that these arrangements are effectively swaps hence be under the mandate of the International Swaps and Derivatives Association (ISDA). ISDA is not a financial regulator but an association similar to a bankers association.

What governments are realising is that they need to disregard the legal definition of CDS and recognise these instruments as a form of insurance. Hence, there is a need to regulate the institutions that issue/trade in CDS to prevent them from failing to honour their commitments incase of a credit event.

For AIG, its AIG Financial Products division was initially able to honour such commitments, but they later realised that it was too much. Hence, they had initially decided to enter into bankruptcy protection before the US Government stepped in.

Hope this helps

Regards

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Permalink Reply by Razni Razak on March 12, 2010 at 3:54pm

Very good David. Thank you.

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