3
$\begingroup$

Reading the wikipedia page for derivatives on 00:02 E.S.T March 21 2016, a credit default swap (CDS) is summarized as being "A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event", and goes on to say "It was invented by Blythe Masters from JP Morgan in 1994".

To a layman like me, this sounds very similar to a bet, and so it seems weird to say this concept was invented in 1994. In what way is a "credit event" distinct from something like a gambling event (like a dice roll or horse race)? Could the credit event be a person losing a bet that party A would win in game X?

Improve this question
$\endgroup$
1
  • 1
    $\begingroup$ A CDS is an investment which is a type of bet. It takes a few forms, you invest if you think you know more than the guy on the other side and hope you'll make money, or you treat is as a hedge so you don't lose as much money in adverse conditions. The idea is the same as investing in Apple, putting your money in a bank, or putting money in a jar on the kitchen counter. Last I've heard, though, the kitchen counter ETF hasn't had very strong returns over the long term. Wikipedia is saying that there was no formal way for investors to "bet" against companies until CDSs were created in 1994. $\endgroup$
    – RandyF
    Commented Mar 21, 2016 at 21:05

1 Answer 1

Reset to default
4
$\begingroup$

The basic idea behind the CDS to provide protection from credit risk to the buyers of corporate bond. They are supposed to be like a insurance product where he buyer of the CDS pay the premium to the seller for the repayment of principle amount if company gets defaulted. But CDS are different from insurance product in two ways.

As pointed by Stulz (2010)

However, the parallel between insurance contracts and credit default swaps does not hold in two important ways. First, you do not have to hold the bonds to buy a credit default swap on that bond, whereas with an insurance contract, you typically have a direct economic exposure to obtain insurance.

Second, insurance contracts (mostly) are not traded; in contrast, credit default swap contracts do trade over the counter—that is, a market where traders in different locations communicate and make deals by phone and through electronic messages. Dealers trade with end users as well as with other dealers.

So, buying CDS without having direct exposure to the company bond is like betting on the fortune of the company.

Improve this answer
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.