Talk:Credit default swap

Insider Trading

This article might need some text about insider trading (and other aspects of missing regulation) of CDSs in the article. I mean situations, in which somebody with insider information of a forthcoming credit event buys protection from said event. I think this is a big issue in the CDS market. Reiska 15:24, 3 August 2007 (UTC)

Anyone with access to insider information usually is supposedly restricted in their ability to transact on it anyway, but even if they do, so what? It's a good thing, isn't it? They've transmitted information to the external market, which will cause other people to be more wary of that company because of the higher spreads. Tristanreid (talk) 17:22, 13 June 2008 (UTC)

CDS Agreements in a Bankruptcy

What about credit risks associated with CDSs themselves? What if the risk seller goes bankrupt after the buyer has paid a lot of premiums? What is the status of the CDS agreement in bankruptcy proceedings? Are there any precedents? Reiska 15:24, 3 August 2007 (UTC)

This is the most important point about cds and nobody ever really thinks about it. If you own a bond hedge with CDS the diff is not free money as some assume, its the price of credit risk of that cparty. If bank risk start to deteriorate the value of your 'hedge' gets severely undermined. The bank may nevr actually go bust, but as LTCM found out, you dont need to have a default for this to cuase some severe pain. The only real way of hedging a bond is by selling it.

Comment2

I guess the CDS will usually be handled like any other item in case of a default. If it has positive market value (protection buyer pays 50 Bp, while current fair value credit spread is only 30 Bp.) the CDS will probably be sold and will continue on. OTOH if it has a negative value (either because of a default or because current credit-spreads are wider) the protection buyer would simply receive its quota.

However, CDS trades are usually not done without CSA (ISDA Credit Support Annex) to limit counterpart risk by margin calls. 194.166.212.120 18:13, 22 August 2007 (UTC)

What about deteriorating bank risk?

It makes sense that the cost of ensuring a weak credit might be 140 ( Philippines for example ) and a weaker bank such as Lehman (cost 110). But what price should a cds with lehman be for philippines? Ive got two risks, Phil AND Lehman. Given spreads are similar probability of default must be similar. If lehman were to go bust before Philippines Id lose my hedge and it may cost me a lot more to replace the contract with someone else. If Phil goes bust the I get my protection unless Lehman then go but as a result (cant meet payements on default). But its not just Lehman, banks in general. It is not true that banks are too big to fail, look at Continental Illiois or Northen Rock? It doesnt seem to make any sense for bank paper to trade close to risky credits as that would imply that they are both as risky. Whats the point of ensuring yourself with an entity that is just as risky? Im sure Northern Rock didnt trade CDs (did they?), but what price would you pay NR to ensure you against other companies defaulting? Nil?

Generally you require the counterparty to post collateral to make up for the difference in the current and market premia. The problem is that this isn't enough to completely ameliorate the counterparty risk, and it also adds the problem of a short-term cash shortfall to make collateral calls (which is the problem with any unfunded asset) Tristanreid (talk) 17:39, 13 June 2008 (UTC)

Question on 2nd example

In the example given under speculation, I don't quite understand why the premium on the CDS would be $100 000.
Zain Ebrahim 09:50, 7 September 2007 (UTC)

Recognized Credit Events

Are rating downgrades recognized credit events? —Preceding unsigned comment added by Gonzen (talk • contribs) 13:55, 19 October 2007 (UTC)

Good question. I'll check and get back to you. If I were to guess, I'd say that there's nothing stopping two counterparties entering into such an agreement. Zain Ebrahim (talk) 22:15, 30 April 2008 (UTC)

Yes, downgrades are credit events. And while two counterparties can enter into any agreement they want, CDS are generally well defined by ISDA agreement. The advantage is that the contract becomes liquid, they can use another contract to unwind the first. Tristanreid (talk) 17:24, 13 June 2008 (UTC)

No, downgrades are not (ordinarily) credit events. PIMCO[1] and others[2] list the most common events on their investor page: basically, debt default, failure to pay on time or unfavourable debt restructuring. The ISDA[3] says that downgrades are only a credit event in ABS, and only in the case of a downgrade below CC (which is pretty much the sign of an impending default anyway). -- Marcika (talk) 08:19, 7 August 2008 (UTC)

Technical minutiae

I've removed the previous edit about CDS trading at par, which is not necessarily the case for cash bonds, because this is alluded to in the preceding sentence about the basis arising from "technical minutiae". Pls feel free to revert my changes or, better yet, provide a list of the technical minutiae that result in the basis. Finnancier (talk) 15:36, 3 January 2008 (UTC)

The hedging example

Just a thank you to the editor, who explained in nice basic terms, the cash flow construct of a CDS transaction between two parties. Helped me understand the concept and logic behind the contract better than many textbooks could! 86.42.229.49 (talk) 23:22, 8 January 2008 (UTC)

The hedging example

Good writing but how are the values in this example calculated? propably obvious but wuold be good to show the calculateions in verbatim format...192.100.116.143 (talk) 11:46, 30 January 2008 (UTC)

"The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably."

The calculation appears to be in error. The loss to the holders of the bonds would be $600 million if they had not purchased a credit default swap, and $0 if they had purchased a credit default swap. The loss to the credit default sellers would be $9.6 billion as there are only $1 billion in outstanding bonds that can be sold for $40 cents on the dollar. Pringle1972 (talk) 19:29, 25 September 2008 (UTC)

Please clarify the first paragraph

If someone stumbles in here who knows that they are talking about, could you please rewrite the introductory paragraph so that it's comprehensible?

"A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement)."

• What is a "reference entity". Is there any relationship between the ref ent and one of the other parties?
• Presumably the "protection buyer" and "protection seller" in the 2nd sentence are the "two counterparties" of the first sentence?
• What does "happening in the reference entity" mean?
• "takes delivery of the defaulted bond": What bond? Is this a bond previously issued by the "reference entity". Is a bond always involved or is this just an example?
• Indeed, does there need to be any actual debt involved for the two parties, or are the "two counterparties" simply betting on something happening?

Thanks 68.7.39.11 (talk) 00:30, 23 February 2008 (UTC)

Firstly, I agree that the opening paragraph is not very comprehensible to a person who does not already understand CDS contracts (i.e. anyone who would want to read this article).

A CDS works as follows. Bank A enters into an agreement with Bank B to trade the credit risk on some counterparty (General Motors (GM) for example). Let's say A has purchased a Corporate bond issued by GM. If GM defaults then A will incur a loss. The CDS will be structured so that if GM defaults then B will cover A's losses.

This is a very simplified explanation and there are several other issues. For example, A need not have any exposure to GM but may still enter into the above agreement for purely speculative purposes.

To answer your questions then:

• GM in this case but it may be any other corporate entity. In fact, as far as I know, the CDS may be entered into without the reference entity even being aware of it.

• Yes. A would be the protection buyer and would usually pay B regular coupons.

• I'm sure you can figure this one out now.

• This is just an example and it should be clarified in the article.

• Yes, that may be the case.

Zain Ebrahim (talk) 14:55, 25 February 2008 (UTC)

Questionable para under "Criticisms"...

The 4th para ("Derivatives such as credit default swaps also create major distortions in the traditional indicators...") seems to be saying that stocks of failing companies aren't sold down in the market--but that, as we all see everyday, is BS. Any company reporting any major performance or credit or accounting issue is IMMEDIATELY cut down to size in the stock market, and this IS reflected in any index that it is part of. So I'm not seeing the basis for this theory that derivatives cause false index stability. At least as far as any major stock index is concerned (e.g. S&P 500). I would like to see some references for this theory, and/or a more convincing presentation of it. If it's purely the author's idle speculation, I recommend this para be removed. Rep07 (talk) 19:12, 25 February 2008 (UTC)

I've removed it entirely, and the paragraph above it as hopelessly POV original research. There are grains of truth in some of what I removed, but the veracity of the material on the whole isn't good enough to justify remaining. The asymmetric information part is salvageable, but needs a source. In order that the material can be retained, but without copying it all here, here's the diff where I removed it. If someone thinks it would be valuable to copy here, go ahead, but it really shouldn't go back in wholesale without some sources and some POV reduction. And here's the diff where an anon added it in the first place. - Taxman ^Talk 15:01, 7 April 2008 (UTC)

I agree with the remove. It was unsourced, mostly incorrect, POV and poorly written. The article is a lot better without it.

But I'd just like to reply to Rep07. Whoever introduced that section into the article wasn't refering to "reports" of a major issue, he/she was merely saying that the big players (JPMorgan etc) would normally have more information than everyone else and instead of selling their exposure to a company that they think might decline, they could simply buy insurance which would result in an incorrect price and hence index value. Zain Ebrahim (talk) 15:25, 2 May 2008 (UTC)

Opening section

I cleaned up the opening section and added a ref. Any comments? Zain Ebrahim (talk) 23:26, 30 April 2008 (UTC)

We need to update this page, post haste! AIG's failure due to its huge credit default swap debt, as well as the sheer scale of this whole mess, has made it incredibly important in the US and global economy. For one thing, the amount of CDS debt now is not $45 trillion, but $70 trillion! This has the potential of bringing down the entire economy, if the whole thing goes balls up. Saukkomies 11:20, 18 September 2008 (UTC)

Incomprehensible

I came here after seeing an item on BBC2's Newsnight, hoping to get some clarification in plain English about what Credit Default Swaps are.

I was totally disappointed.

Anyone who can explain to a layman what is going on, given the enormous sums of money involved, will be doing me a favour. No-one who didn't already know what "CDS" meant would not leave this article much wiser.

cannon— Preceding unsigned comment added by Cannonmc (talk • contribs)

Could you perhaps clarify which part of the first paragraph confused you? A pays B regular payments and B promises to pay A a large sum if C defaults. Please read the first paragraph again and tell us which part of it you find confusing. Thanks, Zain Ebrahim (talk) 08:34, 7 August 2008 (UTC)

Re-gig the first three paragraphs

I know what CDS's are, but the first two paragraphs are way too complicated to introduce people to this rather complex instrument. I suggest starting with the third paragraph, with slight re-gigging to make it a little easier to comprehend. The introduction should start...

A credit default swap resembles an insurance policy, as it can be used by a debt holder to hedge, or insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

Better still, something more like this...

In essence, a CDS is a type of "insurance" taken out on an investment, used to protect the buyer from any potential drop in the original investment value... But a CDS is not generally considered insurance for regulatory purposes; instead the contract is made with another Counterparty such as AIG (company). The issuer of the CDS "instrument", calculates the risks of potential loss, and charges a ongoing fee, the instrument issuer may also pass on part or all of the the risk to further counterparties, making it difficult to trace the original obligation. Also see rating agencies and hedge.

If this is too messy, the parts in parenthesis could be removed. —Preceding unsigned comment added by 88.106.149.106 (talk) 10:58, 21 September 2008 (UTC)

History Needed

Can anyone supply a history of this product? Probably some form of CDS can be traced to the Champagne Trade Fairs of the 12th-13th centuries; their 21st century, thermonuclear application needs elucidation.

teneriff (talk) 19:51, 21 September 2008 (UTC)

credit default insurance

Isn't this also called "credit default insurance"? or is that the insurance version? (i.e. seller actually set up a reserve) --Voidvector (talk) 08:33, 25 September 2008 (UTC)

weasel words

I read the first paragraph, and my eyes glaze over. Can this be rewritten in english please? esp. a version of english designed to enlighten and not to confused. Edward Vielmetti (talk) 06:48, 27 September 2008 (UTC)

Financial WMD's? Global systemic risk?

This article must be getting lots of views from people who want to know why CDS keeps being talked about as the systemic risk that threatens the entire global financial system, and justifies the unprecedented actions of the U.S. Treasury and Federal Reserve. The existing descriptions of Buffet's criticism and of the amplification of the risk associated with some specific liability aren't enough information nor enough scope to address this. --99.163.50.12 (talk) 18:44, 27 September 2008 (UTC)

Bad example - only tells half the story

Under Criticisms: "company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion." This statement of the loss to the CDS sellers ignores the CDS coverage that virtually all these sellers have against loss. I believe the net loss is still only $600 million. The whole reason that $10 billion of CDS contracts are outstanding is that each CDS seller is likely to turn around and purchase another contract for their own coverage. Yes, in case of a default, somebody is going to lose $600 million, but it its't going to be multiplied 10 times after all these insurers cover each other. If I'm wrong, then this section needs citations that I can go look at, which show why the net loss gets magnified. I believe that it's only true in the case when everybody defaults: the original bond seller and all the sellers of the CDS contracts. And even if that happens, I believe the losses would be limited to unrecoverable bond debt PLUS whatever CDS premiums were paid by the buyers. Furthermore, the $10 billion of CDS contracts aren't all outstanding to the company that issued the bonds - they're outstanding to many other parties in addition to some held by that company. I'm'a change that. --99.163.50.12 (talk) 17:22, 28 September 2008 (UTC)