Sunday, September 21, 2008

Credit Default Swaps - The Next Crisis?

What is Credit Default Swaps?

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default or "credit event" in respect of a third party or "reference entity".

If a credit event occurs, the typical contract either settles by delivery by the buyer to the seller of a (usually defaulted) debt obligation of the reference entity against a payment by the seller of the par value ("physical settlement") or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation, typically determined in an auction ("cash settlement").

A credit default swap resembles an insurance policy, as it can be used by a debt holder to hedge, or insure against a default under the debt instrument. However, because there is no requirement to actually hold any asset or suffer a loss, a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes.

Definition from Wikipedia
http://en.wikipedia.org/wiki/Credit_default_swap

Credit Default Swaps: The Next Crisis?

U.S. biggest insurer, American International Group (AIG), recently bailed out by the Federal Reserve, incurred billions dollars of losses due to Credit Default Swaps. An article written on Mar 2008 by time.com wrote a possibility of CDS to be the next financial crisis. It documents the relationship between Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs) and how huge and "explosive" CDS has become.

Credit Default Swaps: The Next Crisis?
http://www.time.com/time/business/article/0,8599,1723152,00.html

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