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86-434: In spring 2008, AIGFP suffered enormous losses from credit default swaps that it issued and traded in earlier years. Company officials issued the swaps believing they would have to pay out few, if any, of them. But as the financial crisis worsened during early 2008, many companies began to default on their debt, forcing AIGFP to assume losses far greater than anticipated. The losses at AIGFP caused credit agencies to downgrade

172-528: A hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $ 10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500 basis points (=5%) per annum. Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses. For example: Transactions such as these do not even have to be entered into over

258-573: A systemic risk . In March 2010, the Depository Trust & Clearing Corporation (see Sources of Market Data ) announced it would give regulators greater access to its credit default swaps database. There is "$ 8 trillion notional value outstanding" as of June 2018. Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives Association (ISDA) , although there are many variants. In addition to

344-429: A CDS as a hedge for similar reasons. Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of $ 10 million. To manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $ 10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection,

430-567: A CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral . The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require payment of an upfront fee (composed of "reset to par" and an "initial coupon."). Another kind of risk for

516-495: A CDS, both the buyer and seller of credit protection take on counterparty risk : In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/ clearing house , such as ICE TCC, there will no longer be "counterparty risk", as the risk of the counterparty will be held with the central exchange/clearing house. As is true with other forms of over-the-counter derivatives, CDS might involve liquidity risk . If one or both parties to

602-407: A bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default . Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular. Because the speculator in either case does not own the bond, its position is said to be a synthetic long or short position. For example,

688-534: A company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve. The investor selling the CDS is viewed as being " long " on the CDS and the credit, as if the investor owned the bond. In contrast, the investor who bought protection is " short " on the CDS and the underlying credit. Credit default swaps opened up important new avenues to speculators. Investors could go long on

774-410: A few specialized investors worldwide. An agreement to exchange future cash flows between two parties where one leg is an equity-based cash flow such as the performance of a stock asset, a basket of stocks or a stock index. The other leg is typically a fixed-income cash flow such as a benchmark interest rate. There are myriad different variations on the vanilla swap structure, which are limited only by

860-403: A gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses ). If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur: The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of

946-494: A huge incentive for arson. Analogizing to the concept of insurable interest , critics say you should not be able to buy a CDS—insurance against default—when you do not own the bond. Short selling is also viewed as gambling and the CDS market as a casino. Another concern is the size of the CDS market. Because naked credit default swaps are synthetic, there is no limit to how many can be sold. The gross amount of CDSs far exceeds all "real" corporate bonds and loans outstanding. As

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1032-414: A particular credit risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under Basel I ). This frees resources the bank can use to make other loans to the same key customer or to other borrowers. Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy

1118-404: A party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no customer base. A bank buying protection can also use a CDS to free regulatory capital. By offloading

1204-524: A portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of mortgage-backed securities . In

1290-461: A result, the risk of default is magnified leading to concerns about systemic risk. Financier George Soros called for an outright ban on naked credit default swaps, viewing them as "toxic" and allowing speculators to bet against and "bear raid" companies or countries. His concerns were echoed by several European politicians who, during the Greek government-debt crisis , accused naked CDS buyers of making

1376-400: A series of forward contracts through which two parties exchange financial instruments, resulting in a common series of exchange dates and two streams of instruments, the legs of the swap. The legs can be almost anything but usually one leg involves cash flows based on a notional principal amount that both parties agree to. This principal usually does not change hands during or at the end of

1462-478: A short position in a floating rate note (i.e. making floating interest payments): From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is, Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is: LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like

1548-445: A single asset or a basket of assets, usually debt obligations. In the event of default, the payer receives compensation, for example the principal, possibly plus all fixed rate payments until the end of the swap agreement, or any other way that suits the protection buyer or both counterparties. The primary objective of a CDS is to transfer one party's credit exposure to another party. A subordinated risk swap (SRS), or equity risk swap,

1634-621: A stock warrant for 79.9% of the equity in AIG, effectively nationalizing the world's largest insurer . Shortly after, U.S. Treasury Secretary Henry Paulson announced the treasury's desire to break up and liquidate most of AIG. The company has since sold off many of its subsidiaries to raise the cash to repay the Federal Reserve. AIG closed AIGFP in December 2022, and the subsidiary filed for Chapter 11 bankruptcy shortly after. Howard Sosin started

1720-532: Is a contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of the underlying (for example a company ). Through execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus, general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC) and there are only

1806-446: Is a generic term to describe a financial institution that facilitates swaps between counterparties. It maintains a substantial position in swaps for any of the major swap categories. A swap bank can be an international commercial bank, an investment bank, a merchant bank, or an independent operator. A swap bank serves as either a swap broker or swap dealer. As a broker, the swap bank matches counterparties but does not assume any risk of

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1892-446: Is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil . An agreement whereby the payer periodically pays premiums, sometimes also or only a one-off or initial premium, to the protection seller on a notional principal for a period of time so long as a specified credit event has not occurred. The credit event can refer to

1978-416: Is an interest rate swap. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage. However, this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This

2064-806: Is available from S&P Capital IQ through their acquisition of Credit Market Analysis in 2012. According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts outstanding in the marketplace." The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S commercial banks and trust companies. Credit default swaps can be used by investors for speculation , hedging and arbitrage . Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as

2150-400: Is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate , such as LIBOR . In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread. A basis swap involves exchanging floating interest rates based on different money markets. The principal is not exchanged. The swap effectively limits

2236-459: Is less likely to default on its debt. However, if its outlook worsens then its CDS spread should widen and its stock price should fall. Swap (finance) In finance , a swap is an agreement between two counterparties to exchange financial instruments , cashflows, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount. The general swap can also be seen as

2322-411: Is linked to a "reference entity" or "reference obligor", usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the "spread" charged in basis points by the seller to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the par value of

2408-415: Is paying a floating interest rate on their mortgage but expects this rate to go up in the future. Another mortgage holder is paying a fixed rate but expects rates to fall in the future. They enter a fixed-for-floating swap agreement. Both mortgage holders agree on a notional principal amount and maturity date and agree to take on each other's payment obligations. The first mortgage holder from now on

2494-451: Is paying a fixed rate to the second mortgage holder while receiving a floating rate. By using a swap, both parties effectively changed their mortgage terms to their preferred interest mode while neither party had to renegotiate terms with their mortgage lenders. Considering the next payment only, both parties might as well have entered a fixed-for-floating forward contract . For the payment after that another forward contract whose terms are

2580-433: Is that without default risk, a bank may have no motivation to actively monitor the loan and the counterparty has no relationship to the borrower. Another kind of hedge is against concentration risk. A bank's risk management team may advise that the bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS. Because the borrower—the reference entity—is not

2666-412: Is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points . Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount . The first rate

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2752-476: The 2007–2008 financial crisis , most observers conclude that using credit default swaps as a hedging device has a useful purpose. Capital Structure Arbitrage is an example of an arbitrage strategy that uses CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it

2838-514: The Federal Reserve . The story of AIGFP losses is substantially profiled in the book The Big Short by Michael Lewis . Credit default swaps A credit default swap ( CDS ) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event . That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of

2924-399: The cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product—which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps . These split by currency as: A Major Swap Participant (MSP, or sometimes Swap Bank )

3010-518: The credit rating of the entire AIG corporation in September 2008. The resulting liquidity crisis essentially bankrupted all of AIG. Many believed that AIG was too big to fail and that an AIG bankruptcy could cause an already fragile financial system to collapse, prompting the Federal Reserve Bank to extend an $ 85 billion line of credit to AIG. As a result, the Federal Reserve was issued

3096-443: The exposure effect that a domestic investor would see for such debt. Financing foreign-currency debt using domestic currency and a currency swap is therefore superior to financing directly with foreign-currency debt. The two primary reasons for swapping interest rates are to better match maturities of assets and liabilities and/or to obtain a cost savings via the quality spread differential (QSD). Empirical evidence suggests that

3182-420: The notional amount . For example, if the CDS spread of Risky Corp is 50 basis points , or 0.5% (1 basis point = 0.01%), then an investor buying $ 10 million worth of protection from AAA-Bank must pay the bank $ 50,000. Payments are usually made on a quarterly basis, in arrear . These payments continue until either the CDS contract expires or Risky Corp defaults. All things being equal, at any given time, if

3268-568: The $ 10–$ 20 million range with maturities between one and 10 years. Five years is the most typical maturity. An investor or speculator may "buy protection" to hedge the risk of default on a bond or other debt instrument, regardless of whether such investor or speculator holds an interest in or bears any risk of loss relating to such bond or debt instrument. In this way, a CDS is similar to credit insurance , although CDSs are not subject to regulations governing traditional insurance. Also, investors can buy and sell protection without owning debt of

3354-531: The A-rated firm would borrow using commercial paper at a spread over the AAA rate and enter into a (short-term) fixed-for-floating swap as payer. The generic types of swaps, in order of their quantitative importance, are: interest rate swaps , basis swaps , currency swaps , inflation swaps , credit default swaps , commodity swaps and equity swaps . There are also many other types of swaps. The most common type of swap

3440-432: The CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, may expect to receive a payoff if the asset defaults. In the event of default, the buyer of the credit default swap receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan or its market value in cash. However, anyone can purchase a CDS, even buyers who do not hold

3526-652: The Chicago Mercantile Exchange, the largest U.S. futures market, and the Chicago Board Options Exchange, registered to become SDRs. They started to list some types of swaps, swaptions and swap futures on their platforms. Other exchanges followed, such as the IntercontinentalExchange and Frankfurt-based Eurex AG. According to the 2018 SEF Market Share Statistics Bloomberg dominates the credit rate market with 80% share, TP dominates

AIG Financial Products - Misplaced Pages Continue

3612-483: The DJ-AIGCI on a global basis. From 1987 to 2004, AIGFP contributed over $ 5 billion to AIG’s pre-tax income. During that period, AIG's market capitalization increased from $ 11 billion to $ 181 billion, and its stock price increased from $ 4.50 per share to $ 62.34 per share. AIGFP's trading in credit derivatives led to enormous losses. These losses at AIGFP division essentially bankrupted the entire AIG operation, and forced

3698-454: The FX dealer to dealer market (46% share), Reuters dominates the FX dealer to client market (50% share), Tradeweb is strongest in the vanilla interest rate market (38% share), TP the biggest platform in the basis swap market (53% share), BGC dominates both the swaption and XCS markets, Tradition is the biggest platform for Caps and Floors (55% share). While the market for currency swaps developed first,

3784-679: The North American CDX index or the European iTraxx index. An investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by entering into a trade, known as a basis trade , that combines a CDS with a cash bond and an interest rate swap . Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on

3870-526: The United States government to bail out the insurer. Under CEO Edward Liddy , the decision was made to unwind AIG Financial Product's entire book of business. Gerry Pasciucco, a vice chairman at Morgan Stanley , who was not involved with AIG FP when it made its catastrophic bets, was selected to manage the unwinding of the portfolio in October 2008, after the company had effectively failed and been taken over by

3956-402: The bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely damage the banker-client relationship. 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 downside to this hedge

4042-404: The basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes ), as well as loan-only credit default swaps (LCDS). Further, in addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset-backed securities . CDS data can be used by financial professionals , regulators, and

4128-414: The beneficial effect of increasing liquidity in the marketplace. That benefits hedging activities. Without speculators buying and selling naked CDSs, banks wanting to hedge might not find a ready seller of protection. Speculators also create a more competitive marketplace, keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer to regulators and investors about

4214-426: The best indicators of the likelihood of sellers of CDSs having to perform under these contracts. CDS contracts have obvious similarities with insurance contracts because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs. However, there are also many differences, the most important being that an insurance contract provides an indemnity against the losses actually suffered by

4300-426: The bill did not become law. Credit default swaps are often used to manage the risk of default that arises from holding debt. 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, the proceeds from the CDS contract cancel out the losses on the underlying debt. There are other ways to eliminate or reduce

4386-425: The bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's credit rating . CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium, and acceleration. Most CDSs are in

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4472-463: The correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short. While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and

4558-583: The counter derivatives and created the Dow Jones-AIG Commodity Index (DJ-AIGCI) from their offices in Greenwich, CT. At that point, the Market and Credit Risk management groups were reduced in size. The DJ-AIGCI is a leading commodity benchmark composed of 19 futures contracts on physical commodities. As of the end of June 2007, there was an estimated $ 38 billion invested in financial products that track

4644-440: The counterparties. The Dodd-Frank Act in 2010, however, envisions a multilateral platform for swap quoting, the swaps execution facility (SEF), and mandates that swaps be reported to and cleared through exchanges or clearing houses which subsequently led to the formation of swap data repositories (SDRs), a central facility for swap data reporting and recordkeeping. Data vendors, such as Bloomberg, and big exchanges, such as

4730-726: The credit default swaps market is available from three main sources. Data on an annual and semiannual basis is available from the International Swaps and Derivatives Association (ISDA) since 2001 and from the Bank for International Settlements (BIS) since 2004. The Depository Trust & Clearing Corporation (DTCC), through its global repository Trade Information Warehouse (TIW), provides weekly data but publicly available information goes back only one year. The numbers provided by each source do not always match because each provider uses different sampling methods. Daily, intraday and real time data

4816-465: The credit health of a company or country. Germany's market regulator BaFin found that naked CDS did not worsen the Greek credit crisis. Without credit default swaps, Greece's borrowing costs would be higher. As of November 2011, the Greek bonds have a bond yield of 28%. A bill in the U.S. Congress proposed giving a public authority the power to limit the use of CDSs other than for hedging purposes, but

4902-570: The crisis worse. Despite these concerns, former United States Secretary of the Treasury Geithner and Commodity Futures Trading Commission Chairman Gensler are not in favor of an outright ban on naked credit default swaps. They prefer greater transparency and better capitalization requirements. These officials think that naked CDSs have a place in the market. Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has

4988-436: The early 2000s. By the end of 2007, the outstanding CDS amount was $ 62.2 trillion, falling to $ 26.3 trillion by mid-year 2010 and reportedly $ 25.5  trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007–2008 financial crisis , the lack of transparency in this large market became a concern to regulators as it could pose

5074-582: The examples above, the hedge fund did not own any debt of Risky Corp. A CDS in which the buyer does not own the underlying debt is referred to as a naked credit default swap , estimated to be up to 80% of the credit default swap market. There is currently a debate in the United States and Europe about whether speculative uses of credit default swaps should be banned. Legislation is under consideration by Congress as part of financial reform. Critics assert that naked CDSs should be banned, comparing them to buying fire insurance on your neighbor's house, which creates

5160-523: The expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding was more than $ 348 trillion in 2010, according to Bank for International Settlements (BIS). Most swaps are traded over-the-counter (OTC), "tailor-made" for

5246-469: The extent that name recognition is truly important in raising funds in the international bond market . Firms using currency swaps have statistically higher levels of long-term foreign-denominated debt than firms that use no currency derivatives. Conversely, the primary users of currency swaps are non-financial, global firms with long-term foreign-currency financing needs. From a foreign investor's perspective, valuation of foreign-currency debt would exclude

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5332-466: The following discussion is for plain vanilla interest rate swaps and is representative of pure rational pricing as it excludes credit risk . For interest rate swaps, there are in fact two methods, which will (must) return the same value: in terms of bond prices, or as a portfolio of forward contracts . The fact that these methods agree, underscores the fact that rational pricing will apply between instruments also. As mentioned, to be arbitrage free,

5418-435: The group in 1987. AIGFP businesses specialize interest rate and currency swaps and, more broadly, the capital markets . AIGFP focused principally on OTC derivatives markets and acted as principal in nearly all of its transactions involving capital markets offerings and corporate finance , investment and financial risk management products. AIGFP played key roles in the acquisition of London City Airport and, in one of

5504-506: The imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures. The value of a swap is the net present value (NPV) of all expected future cash flows, essentially the difference in leg values. A swap is thus "worth zero" when it is first initiated, otherwise one party would be at an advantage, and arbitrage would be possible; however after this time its value may become positive or negative. While this principle holds true for any swap,

5590-456: The interest rate swap market has surpassed it, measured by notional principal , "a reference amount of principal for determining interest payments." The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market . At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product . However, since

5676-440: The interest-rate risk as a result of having differing lending and borrowing rates. A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage . Currency swaps entail swapping both principal and interest between

5762-400: The investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge . But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in

5848-558: The largest private equity transactions announced in 2006, the management-led buyout of Kinder Morgan . AIGFP's commodity derivatives and commodity indices helped stimulate the development of this new asset class. AIGFP's sponsored a major study on the historical performance of commodity futures by professors Gary Gorton and K. Geert Rouwenhorst . AIGFP created a specialized credit business. AIGFP focused its business on structured products like CDO 's. In 2003, it absorbed subsidiary, AIG Trading Group (AIG-TG) which dealt primarily in over

5934-419: The loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction . The payment received is often substantially less than the face value of the loan. Credit default swaps in their current form have existed since the early 1990s and increased in use in

6020-432: The long-term. 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 obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure to

6106-463: The maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be

6192-465: The media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies . Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency. A CDS can be unsecured (without collateral) and be at higher risk for a default. A CDS

6278-412: The parties, with the cashflows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers. An inflation-linked swap involves exchanging a fixed rate on a principal for an inflation index expressed in monetary terms. The primary objective is to hedge against inflation and interest-rate risk. A commodity swap

6364-403: The pension fund pays 2% of $ 10 million ($ 200,000) per annum in quarterly installments of $ 50,000 to Derivative Bank. In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables. Although credit default swaps have been highly criticized for their role in

6450-422: The policy holder on an asset in which it holds an insurable interest . By contrast, a CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. The holder does not need to own the underlying security and does not even have to suffer a loss from the default event. The CDS can therefore be used to speculate on debt objects. The other differences include: When entering into

6536-503: The present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur , C, could: Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase

6622-474: The reference entity. These "naked credit default swaps" allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, CDSs can also be used in capital structure arbitrage . A "credit default swap" (CDS) is a credit derivative contract between two counterparties . The buyer makes periodic payments to

6708-411: The risk of default. The bank could sell (that is, assign) the loan outright or bring in other banks as participants . However, these options may not meet the bank's needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants. If both the borrower and lender are well-known and the market (or even worse, the news media) learns that

6794-496: The same, i.e. same notional amount and fixed-for-floating, and so on. The swap contract therefore, can be seen as a series of forward contracts. In the end there are two streams of cash flows , one from the party who is always paying a fixed interest on the notional amount, the fixed leg of the swap, the other from the party who agreed to pay the floating rate, the floating leg . Swaps can be used to hedge certain risks such as interest rate risk , or to speculate on changes in

6880-416: The seller of credit default swaps is jump risk or jump-to-default risk ("JTD risk"). A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives. Data about

6966-507: The seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event . The CDS may refer to a specified loan or bond obligation of a "reference entity", usually a corporation or government. As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt,

7052-451: The spread between AAA-rated commercial paper (floating) and A-rated commercial is slightly less than the spread between AAA-rated five-year obligation (fixed) and an A-rated obligation of the same tenor. These findings suggest that firms with lower (higher) credit ratings are more likely to pay fixed (floating) in swaps, and fixed-rate payers would use more short-term debt and have shorter debt maturity than floating-rate payers. In particular,

7138-514: The swap bank would receive a portion of the cash flows passed through it to compensate it for bearing this risk. The two primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market , and/or the benefit of hedging long-run exchange rate exposure. These reasons seem straightforward and difficult to argue with, especially to

7224-413: The swap. The swap broker receives a commission for this service. Today, most swap banks serve as dealers or market makers. As a market maker, a swap bank is willing to accept either side of a currency swap, and then later on-sell it, or match it with a counterparty. In this capacity, the swap bank assumes a position in the swap and therefore assumes some risks. The dealer capacity is obviously more risky, and

7310-458: The swap; this is contrary to a future , a forward or an option . In practice one leg is generally fixed while the other is variable, that is determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate , an index price, or a commodity price. Swaps are primarily over-the-counter contracts between companies or financial institutions. Retail investors do not generally engage in swaps. A mortgage holder

7396-437: The terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible. For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to

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