Credit default swap (CDS)

[Praske94]

dssds

[agolakchub]

Hello Bionic Turtle. So in essence we can assume that the protection buyer receives 1 - .30 of the total value of the asset the CDS was bought against correct? I.e. the 1 - .30 = .70 and .70 of the $100 value is $70.

So thats all the buyer receives from the protection seller; but, the buyer also recovers $30 worth of the entire value of the bond - equaling the total value of the bond. Is this the basic way it works

[olusolaaboaba]

thanks so much for the explanation.

apart from counterparty risk, what are the other risks that a CDS bears?

[CoolBeansEntertainer]

THUMBS UP IF JOSH SENT YOU HEAR!

[mspencer02]

Wow. I really wish the Fed had taken a look at this before they tried to figure out Lehman's books. It's a simple description of a derivative which few knew about until it blew the economy up.

[zulfi721]

thanks....

[lilsi19]

10/10, very clearly explained thank you

[theartofluv]

Wow, this is much better than go through 500 pages textbook. Thank you Bionic Turtle. You save me a lot of time (5 min vs. hours), and money.

[Ksabrs45]

Great video. You managed to explain what none of my Finance professors at Generic State University bothered to.

[bryanthebarber]

You could have spoke a little more like the common american if you didn't want to lose people.

[lastmadcow]

hello bionic t. i'd like to ask what happens if the value of the CDS contract rises because of a downgrade of a bond. Then can you sell the CDS to make a profit?

[ThoughtCriminal912]

in other words when you don't trust your investment you buy cds. Sick system and it should be abolished.

[averageworkinggal]

CDSs do allow a bank to short its balance sheet to a counterparty so it is a systemic risk if the bank is unregulated.

[reiser999]

The credit default swaps were issued not to HEDGE but to expand their balance sheets. Capital ratios for the banks were otherwise MAXED OUT, it would not have been possible for them to make loans at the rates that the big banks did without the use of CDS.

[averageworkinggal]

@loser666 - Which is why so many "banking oligarchs" were shown the door when they guessed wrong on mortgages and destroyed their market caps.

Derivatives are pro-cyclic systemic risk magnifiers.

They manufacture black swans out of market movements.

That's why they're financial WMDs.

And they're currently only industry regulated which means unregulated systemic risk-wise.

The bigger the Derivative bubble, the more black swan WMDs.

The 2008 explosion killed $11T of equity in the US and counting.

[reiser999]

The banks were making loans to consumers in an already over-leveraged environment.

That equity should not never have been created to begin with. If it were not for these contracts created out of thin air, consumers would not have had the sufficient funds to speculate nor would they have even been able to consume products by foreigners. This allowed foreigners to accumulate US debt and dollars to make up for their trade deficits. Hence the inflation was never counted in the system at all.

[averageworkinggal]

@loser666 - the inflation was counted in the system, but most bankers failed to see it.

It was called the housing bubble and those Derivatives-obsessed banking oligarchs seeking big bonuses from the big bets that derivatives allow, failed to realize that that's where the inflation was, in the housing bubble.

[reiser999]

No the inflation was never counted in any official statistic and still has not been to this day. The inflation was not only limited to housing and domestic asset prices. The inflation also allowed consumers to purchase foreign goods, allowing for creditor nations of the the US to have trade surpluses. This allowed creditor nations to accumulate treasuries to the extent that they have been doing. This is why there has only been inflation and the US dollar is in long term jeopardy.

[averageworkinggal]

@loser666- "the inflation" is what China's mercantile policy is going to cause for them.

Mercantile policy is causing foreign acquisition of Treasuries to support their dollar peg unfair trade practice.

We're in a deflationary cycle due to the housing bubble crash and subsequent economic meltdown.

$11T in lost wealth is deflationary and actually boosts the dollar due to the massive destruction of dollar-based assets.

Jobs for 700M Chinese peasants are driving the demand for Treasuries.

[reiser999]

No, china is not mercantilist China was only buying treasuries as part of an arrangement where in exchange the US would open up its market and give tech transfers to China. Japan and SK also participated. No the destruction of dollar based assets causes inflation. The dollar right now is propped up in he world by foreign demand, or foreigners holding dollars. There is not enough money to soak up all future treasuries. China's economy is only 1/3rd exports, they will do much better than the US.

[SeanUK05]

Do you have any other materials showing how to price CDS or compute swap rate on the basis of Excel? or any materials that you would recommend? Any tips will be much appreicated!!

[jaymantis]

that's the OrmEmber example, a few comments down

[stankwho]

Basically no different then sports betting. The whole reason the financial system is in a shithole.

[MyFreeCredit]

Nice vid. Thanks for sharing.

[flangelet]

Gambling is illegal in many states in the usa but who needs poker/horseracing when you can 'bet' on whether Chrysler will go Chapter11 or your nearest bigcity will default on its bond obligations next year, as many did post-1929! (This week's big shock to the system! LOL)

Betting is for smalltimers & losers... CDSs are for the real high rollers!

Read "Liars Poker" or "The Black Swan" or "Fooled by Randomness or "The Great Crash of 1929 by JK Galbraith" for more economic humour... and horror!

[Brainman94]

no - betting is for losers - derivatives are for losers. There's no difference.

[flangelet]

So why aren't you buying any?

[OrmEmber]

Thanks Bionic Turtle! Sometime if you could explain the equation "1-recovery rate" that would be great. But at least it makes a little sense now.

[bionicturtledotcom]

Thank you OrmEmber. 1 - recovery = loss given default (LGD). If a $100 bond defaults, something is typically recovered. Say $30 is recovered. In a cash settlement, the protection seller pays only 100 - 30 recovered = $70 lost to the protection buyer because the buyer recovers $30. So, the buyer is kept whole with $30 recovered + $70 (=1-recover) = $100

[jaymantis]

So in this example, if I did not own the $100 bond, would i only receive $70 because I wouldn't be entitled to the $30 recovery?

or

would i be required to buy the bond to deliver it to the protection seller?

[bionicturtledotcom]

right, if the contract calls for cash settlement, and you didn't own bond, you'd only receive $70.

Re: would you be required to buy the bond. The cash versus physical has typically been set initially (at the time of contract). Sometimes, a physical can go cash, but ultimately it's contractual.

[jaymantis]

thank you so much. i really appreciate the response.  you are doing great work. please keep it up!

[averageworkinggal]

It seems that options trading in CDSs, without ownership of the reference asset, may be the doomsday weapon that people fear.

Just watch the rise in Fed rates, buy CDSs and collect big bucks in a few months when the economy recedes.

Buy all the CDSs you can during a Fed-induced boom and wait for the inevitable crash and collect trillions. It's such an easy bet.

Why would anyone in their right mind sell CDSs in a boom to a non-owning counterparty?

[reiser999]

The banks themselves do not have the collateral to cover their Credit default swaps. They have issued them for a number of years now not to hedge their balance sheet positions, but to expand their balance sheets. They made loans that they otherwise would not have been able to make.

[averageworkinggal]

@loser666 - you mixing yourself up.

Banks BOUGHT CDSs to expand their balance sheets.

It better to say that banks exposed themselves to systemic counterparty risk from their CDS-induced overleveraging.

It's not the purchasing bank that has to have the collateral for the CDS per se.

AIG blew up - on CDS collateral calls.

But the purchasing bank increases its exposure to counterparty and overleveraging risk.

I clearly know derivatives better than you.

[reiser999]

NO without the use of credit default swaps banks would not have been able to expand their balance sheets to the extent that they did. Their capital ratios were otherwise max out.

You clearly cannot understand basic english.

[reiser999]

*maxed out

[cheeseheads321]

any guys have a cam? i have mine in my profile B

[drvbrick]

good explanation. bet your vid is getting more views now.

[lumbage]

Gotcha!  Thanks very much!

[lumbage]

Thanks bionicturtle, but I am not sure what you mean by "the cash settlement is meant to arrive at the same place: notional - final post default price." I am a layperson...

[bionicturtledotcom]

sorry, i mean if the (protection) buyer "physically settles" the he/she delivers defaulted bond and receives full notional (net gain = notional - defaulted bond). If he/she settles with cash, receives cash = notional - defaulted bond price. Either way, it's the the loss (notional - recovery). David

[bionicturtledotcom]

for example, bond value = $100. Defaults and triggers CDS payout. Post default bond price = $30 (i.e., recovery estimate is 30%).

Cash settle: CDS protection seller pays $70

Physical settle: CDS buyer delivers ( by first purchasing) defaulted bond worth $30 and receives $100. Net "gain" also = $100 - 30 = $70

[lumbage]

So the "reference asset" does not have to be owned by the buyer, and in the event of the "credit event" being triggered, the buyer has to either transfer the "reference asset" itself, or the equivalent cash value of the "reference asset" to the seller.

If the buyer does not own the "reference asset" and must transfer the cash value equivalent how is the value determined?

[bionicturtledotcom]

lumbage: correct, the protection buyer does not need to own reference. If the buyer does not physically deliver the bond to settle the CDS, then the cash settlement is meant to arrive at the same place: notional - final post default price. That way the seller is covering only the loss not the entire. Lehman bond (e.g.) CDS are currently at post-default pricing @ only about $0.09 on the dollar, so the protect seller is paying $0.91 to cover the lost amount.

[sgentry777]

Must a seller of CDS protection show a contingent liability on balance sheet?

[bionicturtledotcom]

Yes, per FAS 133, but unlike a loan where the full loan books as liability, the notional (exposure) on a CDS is not booked. The fair value of a CDS at inception should be near to zero, but is has significant exposure. AIG booked its written CDS as liabilities, but their estimates were way off. Given the zero-value-at-inception, many would argue that disclosure trumps the point liability estimate

[sgentry777]

Thanks very much. So if I understand correctly, gun shy counterparties can only rely on a company's (or their auditor's) "estimates" in assessing this risk. If so (and given the size of the CDS market), I can't understand how $700b can possibly 'unfreeze' the crdit markets.

[bionicturtledotcom]

right, they can run scenarios. But they know the potential exposure: the notional (i.e., default with little recovery). The thing is the CDS is unfunded, so you had small hedge funds writing protection they could not cover. Re the $700b, me neither can i understand....

[chuckchode]

I still am having trouble understanding why I don't have to own the asset...

[bionicturtledotcom]

It's just a bet between two counterparties. I will pay you $5/month for five years (the CDS premium) unless and until Corp XYZ defaults. If it does, you make a payoff to me. It's a derivative, so it's not much different than if our trigger is "cat 5 hurricane hits Florida" or "Tom Brady is injured"

[fistylo]

indeed very clear .congratulations to try to spread your how know

[erwin1999]

Good Video .Question, CDS is not equal bond right. And it should be high rik investment compare to traditional Bond, thanks.

[sashman00]

Thanks David, great explanation. Really enjoy the tutorials.

[bionicturtledotcom]

Thanks for your feedback and thoughtful questions.

[sashman00]

Going back a step, i thought short cds was buying protection. Eg, say im a trader for Lehman (joke), and ive got short risk (bought protection) on IBM at 100bps vs a counterpart who is effectively long the cds taking on all the risk. Spreads widen 100bps to 105bps i make money yes? And if i revalue recovery from 30 to 40 i lose 10%. To clarify recovery, on default of a company, the insurer (protection seller), pays the counterpart 1-R? Many thanks for your time.

[bionicturtledotcom]

If you buy protection, it is "shorting the reference" bond: you are long the CDS instrument and short the reference. As buyer you short the credit risk (the reference, not the CDS). Re spreads widen, no, you do not make money unless the CDS is marked to market (spread changes do not trigger). 1 - recovery is only in cash settle to keep you whole; e.g., you recover 30%, seller pays the other 70%. If you recover 40%, seller pays you other 60%. In theory, you should recover the entire par. David

[disdanic]

Thanks for that, very clearly explained

[sashman00]

Question, if im short the CDS and increase the recovery from 30 to 40% does this mean my recovery value decreases based on the (1-Rec rate) formula? Thx

[bionicturtledotcom]

To be short (long) the CDS is to be the protection seller (buyer), which is to be long (short) the reference. If recovery increases from 30 to 40%, then yes indeed cash settlement (par - market value of recovery) would decrease by the 10%. This is a huge issue in CDS settlements on Fannie and Freddie; pennies on the recovered dollar translate into huge CDS settlement amounts.

[quillendaniel]

I dont have any real problems...but then again I do have some background in finance, accounting and economics......

[Sclorched]

Anyone else have real problems trying to understand this stuff? I think I]m just an idiot.

[quillendaniel]

How relevant this is to today's financial crisis.....AIG is at least in part in trouble over credit default swaps...

[quillendaniel]

Wonderful stuff; thank you for your beautiful explanations.

[bionicturtledotcom]

jrb05 - single name CDS contracts don't (yet!) trade on exchanges; rather they are over the counter (OTC), intra-dealer brokers match institutional buyer and seller (e.g., bank, monoline, hedge fund). David

[KLguy133]

So these would be money brokers ? Do the banks themselves act as intermediaries sometimes as well?

[jryb05]

Recently watching a special on television I saw where some investors have become millionaires by Credit Default Swaps. I am recently trying to research all of the information I can about Credit Default Swaps and I have som questions; Who does the "investor/buyer" buy a credit default swap from? As a general example If I want to buy a Credit Default Swap on General Motors (GM) where would I go? What steps would I need to take?

[bionicturtledotcom]

I regret the term 'investor' on the left, to your point. The counterparty on the right (protection seller) is arguably an investor. The CDS buyer (who pays the premium) may or may not own the asset; he/she, irrespective of ownership, is purchasing default insurance from the CDS seller (on the right). This buyer does not control default, it is contractually stipulated to terms, but this buyer incurs counterparty risk: trusts that the seller will honor the unfunded obligation. David

[PTLightening]

I hope you will be patient...I am trying hard to understand this.  Let me put it this way. As a protection buyer/CDS lets say I decide to insure my neighbors mortgage. HIs mortgage holder the entity. Now I pay a premium/my neighbor defaults...how do I make his bank deal with me/counterparty with relative to the liquidation/disbursement of asset. What is the entity's role if the protection buyer doesn't own the asset? What connects them?

[bionicturtledotcom]

Re your example; i.e., you buy a CDS on neighbor's mortgage bond. First, it's a CONTRACT (incl. ISDA definition of default) btwn you and CDS seller. If neighbor defaults, settlement can be either physical or cash. If physical, you must deliver to defaulted bond or a SIMILAR bond [many details, but you are not nec. tied to the defaulted bond], they return cash. If cash, seller simply pays you net recovery. Under cash, transaction never leaves the two party contract (very much a derivative!) David

[KLguy133]

So I would in effect be taking a punt on my neighbour defaulting or I must be a VERY good friend of his. Also what do you mean "pays you net recovery " ? Debt obligated amount - any sums received as debt payments ?

[bionicturtledotcom]

default doesn't typically mean the entire notional (bond, loan) is lost. There is typically some recovery. So the protection buyer only receives (notional - whatever is recovered). David

[PTLightening]

This is very good.... but I am having a difficult time understanding the entity's role relative to the investor/protection buyer. You say the investor does not own the bond...so how is it that they are an investor. In what way did they invest? How is it they can control what happens then during default?

Can someone help me with this part??

[LoneOarman]

It was a loop hole in the gambling laws, which excluded investors. The investor did not own the bond, but was allowed to buy insurance anyways. It's like buying insurance on your neighbors house.