Processing Knowledge

One of my previous posts talked about derivatives which is a is a widely used financial instrument. As its name suggests, the value of the derivative is derived from the value of something. Many KPOs and financials researchers analyze credit default swaps. A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument goes into default (fails to pay).  The credit instruments traded are usually bonds or loans.

An Example:

Imagine an investor Alice buys a CDS from the Big Brother Bank. The reference entity of this CDS is the loan taken by Bob. Alice will make regular payments to the Big Brother Bank which the Big Brother can use to give Bob. If  Bob defaults by not repaying the loan installment then Alice receives  a one-off payment from Big Brother Bank followed by the termination of the CDS contract. I came accross a nice illustration by nowandfutures.com that gives a nice overview of CDS.

CDS Overview

Mistake of treating a CDS as Insurance:

The article on credit default swaps, shows how the net exposure can be neutralized. However, this practice was not followed by some of the insurance majors such as AIG. This is considered by many financial researchers as  the source of the current credit crisis

A Surgeons Knife

Like many financial instruments the CDS is like a surgeons knife. If comprehensive analysis and detailed study of the swap is done then problems such as those encountered cannot happen else they can be used as tools for large scale destruction.