Credit default swaps are insurance against the default of bonds. Here are the pros, cons, examples, and how they created several crises. Definition of 'Credit Default Swaps' Definition: Credit default swaps (CDS) are a type of insurance against default risk by a particular company. The company is called the reference entity and the default is called credit event. It is a contract between two parties, called protection buyer and protection seller. In a credit default swap (CDS), two counterparties exchange the risk of default associated with a loan (e.g. a bond or other fixed-income security) for periodic.


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You were caught with the hot potato. Jimmy's hospital realizes his insurer credit default swaps cover his costs and releases him, but he still requires care. So Jimmy sues you to pay up, but you just blew all of your money completing your collection of Pat Boone albums, which suddenly doesn't seem like such a good investment.

Even worse, a trove of Boone's albums was discovered in the estates of some recently deceased collectors, and the market value of your collection plummets.

You sell the collection for half of what credit default swaps paid for it and put it toward Jimmy's health care costs, but it's a drop in the bucket.

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Ultimately, you're forced to declare bankruptcy. Clearly, the sympathetic character here is poor Jimmy, who'd innocently taken out an insurance policy and is guilty only of suffering a car accident. And -- in a stunning turn of misfortune -- both of those people suffered a catastrophic accident as well.

Jimmy's injured and out of work; he's got his own problems and can't pay out on the claims any more than you can. If Risky Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.

Credit default swaps are also used to structure synthetic collateralized debt credit default swaps CDOs. Instead of owning credit default swaps or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS.

Naked credit default swaps[ edit ] Parts of this article those related to legality of naked CDS in Europe need to be updated.

What are credit default swaps? | HowStuffWorks

Please update this article to reflect recent events or newly available information. November In the examples above, the hedge fund did not own any debt of Risky Corp.


credit default swaps Legislation is under consideration by Congress as credit default swaps of financial reform. Analogizing to the concept of insurable interestcritics say you should not be able to buy a CDS—insurance against default—when you do not own the bond.

Because naked credit default swaps are synthetic, there is no limit to how many can be sold.

Credit default swap

They prefer greater transparency and better capitalization requirements. Proponents of naked credit default swaps say that short selling in credit default swaps forms, whether credit default swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace.

Without speculators buying and selling naked CDSs, banks wanting to hedge might not find a ready credit default swaps of protection. A robust market in credit default swaps can also serve as a barometer to regulators and investors about the credit health of a company or country. Congress proposed giving a public authority the power to limit the use of CDSs other than for hedging purposes, but the bill did not become law.


A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, credit default swaps proceeds from the CDS contract cancel out the losses on the underlying debt.

The bank could sell that is, assign the loan outright or bring in other banks as participants. Consent of the corporate borrower is often required.

The bank may credit default swaps want to incur the time and cost to find loan participants. In addition, the bank simply may not want to sell or share the potential profits from the loan.

By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. The bank can lay off credit default swaps of this risk by buying a CDS.

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