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.

Many a times we come across the word derivatives. Warren Buffet once called derivatives, “financial weapons of mass destruction”. Images of stock markets usually show derivatives traders talking about derivatives. Financial Analysts such as those working at KPOs such as S G Analytics  usually flash their experience on equities and derivatives. So what exactly are derivatives? Derivatives is a widely used financial instrument whose value is derived from the value of something else. The most frequently asked question by any naive investor is “Can one predict values of a financial instrument?”. However, as the markets are not deterministic, the question asked by equity researchers is, “How to model the time evolution of prices of financial instruments?”.

Types of Derivatives:

The most widely used derivatives are

1. Forward Contracts – is a formal agreement  between any two parties to buy/sell an asset at a fixed time in the future. For example, Barney who is planning to shift from New York to Paris in 6 months time agrees to sells his car to Fred for $1000.  This money is exchanged in 6 months time irrespective of the market condition and fluctuations in the market
2. Futures contract – is a contract, traded in a futures exchange,  to buy/sell at a specified date in the future at a price specified today
3. Swap contract – is a derivatives where two parties agree to exchange one cash flow for another.

The  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.  Many consider the lethal combination of NINA (“No Income No Assets), falsified information of borrowers income, and CDS as the primary causes of troubles of many large insurance firms such as AIG and the foreclosure spiral that has engulfed the housing sector.

Further Reading:

A nice articled titled, “Barnyard Basics of Derivatives”, gives a crisp overview of how derivatives work. Lately these instruments like all other financial instruments have come under sharp criticism, however to be fair, like all mathematical tools, derivatives have their own set of pros and cons.