From Wikipedia, the free encyclopedia
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 (typically a bond or loan) goes into default (fails to pay) . Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded.
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:
• The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. In contrast, to purchase insurance, the insured is generally expected to have an insurable interest such as owning a debt obligation;
• the seller need not be a regulated entity;
• the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;
• insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets;
• in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;
• Hedge Accounting may not be available under US Generally Accepted Accounting Principles (GAAP) unless the requirements of FAS 133 are met. In practice this rarely happens.
While often described as insurance, credit default swaps differ from insurance in many significant ways. The cost of insurance is based on actuarial analysis. CDSs are derivatives whose cost is determined by the Black-Scholes option pricing model.
This Sums up the fleecing of America by Wall Street Very well.
Insurance contracts require the disclosure of all risks involved.
CDSs have no such requirement, and, as we have seen in the recent past, many of the risks are unknown or unknowable. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claims. In that respect, a CDS is insurance that insures nothing.
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