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Credit Default Swaps

Credit Default Swaps. Luke N. Helm BA 543 Spring 2011. Agenda. Definition Terminology History The Credit Crisis and Current Events. Definition. Credit default swaps transfer credit risk Allow the bank to maintain ownership of the loan

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Credit Default Swaps

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  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.

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