1. Credit Default Swaps Luke N. Helm BA 543 Spring 2011

2. Agenda • Definition • Terminology • History • The Credit Crisis and Current Events

3. Definition • Credit default swaps transfer credit risk • Allow the bank to maintain ownership of the loan • Clean up the balance sheet to increase capital reserves • Discrete

4. Definition • “The protection buyer pays a fee to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit event by the reference obligation or the reference entity.” (Fabozzi et al, 2010)

5. Terminology • Protection Buyer • Protection Seller • Reference Entity • Reference Asset or Obligation • Swap Premium • Basis Points • Spread

6. Terminology • Credit Event • Default on the loan • Eight events as defined by the 1999 ISDA Definitions • Payment • Physical Settlement • Cash Settlement

7. History • Early 1990’s—Invented by Wall Street • 1997—JP Morgan’s BISTRO product • 1999—ISDA Definitions • 2000’s—Market explodes • Unregulated, OTC

8. Market Growth, Credit Default Swaps. (NY Times, 2008)

9. History • 2008—Credit Crisis • AIG, Lehman Brothers • Immediate calls for regulation • Dodd-Frank • 2011 • No real reform • Basis points for credit ratings • Greece

10. Definition • “Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss” (NY Times, 2011)

11. Similarities to Insurance • Premiums • Protection from risk

12. Differences to Insurance • The protection buyer does not need to own the asset • No required reserves • The CDS can be sold with out consent of protection buyer

13. Uses • Hedging • Speculation • Arbitrage

14. Sources • Morgenson, G. (2008, February 17) http://www.nytimes.com/2008/02/17/business/17swap.html?ref=creditdefaultswaps • Morrissey, J. (2008, March 17). Credit default swaps: The Next Crisis. Retrieved May 10, 2011, from Time magazine website:http://www.time.com/time/business/article/0,8599,1723152,00.html • Credit Default Swap. (2011, May 23). Retrieved May 25, 2011, from Wikipedia website:http://en.wikipedia.org/wiki/Credit_default_swaps • Fabozzi, F., Modigliani, F., & Jones, F. (2010). Foundations of Financial Markets and Institutions Fourth Edition. Boston: Prentice Hall.