by Houghton and Atkeson 09/29/08
With several, formerly mighty investment giants having fallen in recent days and weeks, a great deal of interest has been generated in the credit-default swap (CDS) market, which is a common denominator in these banks' business dealings.
Just as options are derivatives of their underlying stocks, credit-default swaps also fall under the "derivatives" umbrella. Just like you can use put options to "insure" your portfolio, investors use the CDS market to spend a small amount of money for the possibility of making a large amount of cash if a company performed poorly.
HOW DO SWAPS WORK?
A credit-default swap is a credit derivative between two parties, whereby one makes periodic payments to the other and receives the promise of a payoff if a third party defaults.
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The former party receives credit protection and is said to be the "buyer" while the other party provides credit protection and is said to be the "seller." The third party is known as the "reference entity."
A simpler way to think of it is to compare it to an insurance policy you might buy to protect your home or your car. You pay the insurance company premiums over the life of the policy and, if something happens, the insurance company pays to fix or replace whatever was insured.
Credit default swaps were first traded in the Interbank market in 1997 but have grown rapidly since, with national volume of $62.2 trillion in 2007 -- that's up 81% from $34.50 in 2006.
What started out as a plain-vanilla market on single-company names now includes indexes, baskets, constant maturity and recovery swaps that all add to the liquidity in the marketplace.
The price movements in the CDS markets reflect the participant's opinion on the financial health of a company. This is similar to corporate debt in that wider spreads are associated with weaker credits. It is different than corporate bonds in that the CDS market is not subject to the same liquidity constraints.
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