[Closed] Any one know about credit default swaps?

I havent traded in them but Im familiar with how they work/what they are.

What's the qu?

I need to have a basic working knowledge on what they are, who would use them, when and why. (I have an exam coming up which covers a wide range of things financial, and CDSs are completely new to me.) I have read the text time and time again but it isn't sinking in.

Is that something you can help with?

A CDS is little more than an insurance product to protect a lender from a default (or other credit event like bankruptcy etc) on his loan to the borrower.

The lender arranges his insurance with a counterparty and the borrower has no involvement.

The "insurance" is linked to a specified loan object (might be a bond for example) and it is default of any payments due under THAT object only that triggers the insurance pay out.

The pay out is usually the face value of the bond that has been defaulted

This is a tool of hedging and helps investors cover exposure as well as provides an opportunity for arbitrage where the cost of the insurance is less than the risk premium on the debt.

You can buy this insurance without actually owning a loan to the borrower - thats called a "naked" CDS. Again you peg the insurance to a specific debt object and are now effectively gambling that the borrower will default and youre betting that the chance of that is higher than the chance reflected by the market pricing of the insurance premium (margin).

The margin is quoted as a percentage of the debt being insured, say 40bps (40bps = 0.40%) per annum, usually paid in quarters and usually for a term specified.

Sovereign CDSs are big news at the moment with Angela Merkel and Sarko threatening to ban naked CDSs in sovereign bonds because they seem to erroneously think that people betting on a falling currency exacerbate things too much. Rather smacks of shooting the messenger to me.

Does that help? Ask away if you want anything clarified. As I said, Im not a pro at CDSs but have seen them used.

Thanks Stoner I'll look back at my notes and see where your comments tie in. I do understand a bit more now... would it be better to email you with any more questions?

feel free, although Im sure the likes of TJ and Ernie are also keen to understand how to make money by betting against an institution! 😉

Im sure the likes of TJ and Ernie are also keen to understand how to make money by betting against an institution!

Very good!

As a basic explanation Stonor is pretty much there, however they are generally physically settled so if a referenced entity triggers the default then a bond meeting the terms of the agreement needs to be delivered. Cash settlement was common before the Long Term Capital Management collapse but following that physically settlement became the market standard. Normally a wide variety of bonds or loans would be deliverable under the contract, likewise the default clause would typically cover all bonds, loans of the issuer but can be even wider.