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Credit Derivatives

 

"Credit Default Swaps" Next Domino of The Global Credit Crunch?

Created by : Gandhi Rajan, Sr. Associate, ICICI Securities  | 11 29 2008 05:15:51 +0000
Industry : Investment BankingFunctional Area : Derivatives(Markets)
Keywords : Next Credit Derivatives Swaps Credit Default Swaps Domino Global Credit Crunch
Activity:  380 views;  last activity : 07 06 2010 20:18:09 +0000
Credit Default Swaps (CDSs) are instruments used for loans and bonds, and effectively act as an insurance policy on corporate debt. The trades also allow speculation on a company's ability to repay the debt. Since the credit-default swap indices are benchmarks for protecting debt against default, traders have been increasingly utilising them to speculate on shifts in credit quality. So the question now is can it be used as next vehicle to counter the global credit crunch?
  
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The global market for CDSs has rocketed over the past four years as they have been widely utilised by the thinly capitalised off-balance sheet vehicles created and/or utilised by large financial institutions -- banks, insurance and reinsurance groups, hedge and investment funds. The total amount of outstanding CDS derivatives' trades worldwide is notionally USD 46 trillion. This CDS market dwarfs the markets in US stocks (USD 22 trillion), mortgage securities (USD 7 trillion) and US treasuries (4.5 trillion). CDSs have been widely used by the thinly capitalized off-balance sheet vehicles created and/or utilised by financial institutions over the past few years, and so these could struggle to find the money required if the derivative contracts are triggered, creating so-called counterparty risk for those expecting to be paid.
By Gandhi Rajan, Sr. Associate, ICICI Securities  | 11 29 2008 05:15:51 +0000
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Though credit-default swap indices are benchmarks for protecting debt against default, traders have been increasingly utilising them to speculate on shifts in credit quality. A basis point, or 0.01%, is typically equivalent to USD 1,000 on a credit default swap that protects USD 10 million of debt from default, a leveraged protection of 10,000 times. The contracts were originally developed to protect bondholders by paying the buyer face value in exchange for the underlying securities should the borrower default but were not envisaged to become massive engines of speculation themselves. This massive speculative element with CDS derivatives also creates a "Weapon of Mass Destruction" WMD effect in the financial world with unintended and unenvisaged consequences.

By Santosh Bhosle, Associate, IFCI  | 11 29 2008 05:18:24 +0000
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