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Credit Default Swaps

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Re: Credit Default Swaps

Unread postby Tanada » Sun 09 Aug 2020, 23:31:44

Much, much longer article at link below the part I quoted.

Credit Default Swaps: Part I Of III - A Brief History Of Mechanics, Product Types, And Standardization

Summary

This prefatory article is the opening of a tripartite series focusing on the most widely used type of credit derivative - credit default swaps.

Part I presents investors with an introduction to these derivatives - namely, the history, mechanics, and product types.

Part II expounds upon credit default swap valuations and provides examples.

Part III culminates in describing some of the indices market participants track these credit default swaps on.

Preface | The Spark of this Series

This series spawns from a recent interview I had with an investment bank for a role in the risk department as a hedge funds analyst. The management asked for an explanation surrounding the mechanics behind credit default swaps and how they are utilized to manage risk for hedge fund clients.

Besides being a great interview question at the time, given the state of our economy, I thought it was an informative topic to delve into in order to sharpen some of the knowledge learned about the credit derivatives space and share with investors who may be interested.

Furthermore, a large swath of our population remains unfamiliar with such instruments that play a vital role in our financial system. Perhaps, this series can provide some information to those who want to read a fair analysis of these products - outside of what they hear from politicians and the financial press.

The following information in this series will not glean insight into certain trading strategies, nor will it reveal any proprietary information belonging to other companies' dealings with credit default swaps. It will only serve the purpose to explain what these derivatives are and how they are used, priced, and where to find them.

A historical backdrop of real-world events and theater will be added to the end of each section to provide the subject matter a dash of flavor - how they have been utilized in a practical sense is just as important and will hopefully keep the material as interesting as possible.

Per the usual disclaimer, this is not investment advice, and I am not being paid for such a post by any institution, except for Seeking Alpha. It is born out of pure interests - writing, history, and financial markets - that I write this series. I hope investors find it to be a good read but, more importantly, find it to be beneficial for their respective endeavors.
Investment Thesis | Alternative Beta

As corporate defaults climbed higher last quarter and credit downgrades hit new records, curious accredited investors may be interested in alternative investments to hedge, speculate, or find arbitrage opportunities during such states of uncertainty.

Prudent measures can be taken in times of duress outside of allocating investments in US treasuries, gold, and other traditional assets. Among the many ways to protect a portfolio is through alternative beta - more precisely, credit default swaps.

The goal - as mentioned in the preface - is for hedge funds, pension plans, and policymakers to benefit from this comprehensive review. Reading about the history, mechanics, and evolution of CDSs will allow institutional investors to consider whether it is a good fit.

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A Brief History | Credit Derivatives & Credit Default Swaps

In order to understand credit default swaps, investors must first understand the term credit derivative. A credit derivative is a bilateral contract that isolates specific aspects of credit risk from an underlying instrument and transfers that risk between two parties. The payoff depends on the creditworthiness of the underlying instrument. Credit derivatives include:

credit default swaps (CDSs)
collateralized debt obligations (CDOs)
total return swaps
credit spread forwards
credit default swap options

In large part, these products were created because banks had little room to maneuver once assuming credit risk and due to the fact that credit had remained a business risk for which no tailored risk-management products existed. Over time, financial innovation and the demand for such products served as a catalyst to bring them to the marketplace.

The acceptance of these credit derivatives filled the gap. Products such as the above-mentioned have allowed these institutions to actively manage their portfolios of credit risk by entering into such credit derivative contracts to hedge their portfolios or speculate for gains. It is a financial innovation that allows for risk to be transferred but not destroyed - such is the nature of risk itself once created.

The largest benefit for institutions may be the fact that credit derivatives allow users to reduce credit exposure without physically removing assets from the balance sheet. Banks find this quite appealing and understandably so.

Therefore, banks have historically been the biggest buyers of credit protection, and insurance companies have been the most prominent sellers. If one would like to do more reading on the different product types and offerings of credit derivatives, this March 2001 Lehman Brothers report provides insight into the instruments that are still used today:

Regarding the recent trends in notional amounts, the growth of credit derivatives came alongside the dot-com bubble in the late 90s. In 2000, the notional principal for outstanding credit derivatives totaled approximately $800 billion. Only 7 years later, that amount spiked to $50 trillion. Later, in 2012, it fell to half of that at around $25 trillion.

Among these credit derivatives is the subject of this series - credit default swaps. Credit default swaps, or CDSs, are the most widely-used credit derivatives.

The first CDSs were created and traded by JPMorgan around 1997. This in-depth interview with Terri Duhon - an ex-JPMorgan swaps trader from 1994-2002 and a pioneer in the CDS space - gives a first-person perspective on the nature and function of these swaps.

Since then, these instruments have been both revered and scorned. The former due to the protection these derivatives provide as a hedge and the latter due primarily to the systemic risks they pose as evidenced in the fallout of AIG in the 2008 Global Financial Crisis, explained later in the epilogue.

As of 2019, credit default swaps were the third-largest OTC derivatives market in the world behind interest rate and foreign exchange derivatives. The latest quarterly report issued on June 26, 2020, from the Office of the Comptroller of the Currency notes that CDSs are the dominant product among credit derivatives - representing approximately $3.5 trillion or 87.5% of all notional amounts. The composition of these derivatives for the 1Q 2020 can be found below:

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It is apparent that the birth of credit derivatives was a watershed development for credit risk management departments within the financial and insurance industry. They continue to fundamentally change the way that banks price, manage, transact, distribute, and account for credit risk.

Hopefully, the following sections regarding these derivatives and, more specifically, CDSs, will give investors a clearer picture and mitigate the cognitive dissonance that surrounds these financial instruments espoused by politicians and the financial press.


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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Tue 11 Aug 2020, 14:53:25

One thing to remember about these, is it's basically insurance. In most years, the people selling these things will make huge profits, as little to nothing bad happens re the overall economy and credit.

Occasionally, a bad economic year or two, often caused by something unexpected (COVID-19, for example), will cause extensive credit events, and the folks selling these things will have HUGE losses.

Generally, there isn't much hype and talk of doom when Berkshire Hathaway, for example, has a bad year re insurance events like floods, earthquakes, etc. And of course, most of the time, they have tremendous profits when not much happens, and all those premiums are net gravy.

As the previous post shows, the risk profile of the swaps (nice pie chart near the end of the piece) is well distributed re both risk and timing. Naturally doomers will point to ANYTHING they can as "doom", but in reality, these CDS's are probably good things in terms of overall, providing a way to reduce risk -- even though SOME sellers of those will lose LOTS of money.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Sun 27 Dec 2020, 14:41:31

Wow an eleven year gap in a thread!!
My problem with CDS is this. You can insure your house for fire or other loss but not your neighbors or that crack house down the street.
They allow you to buy a CDS against bonds you did not write or own.
That made it a casino where betters could place bets on any unsound instrument they thought would default and banks sold hundreds or even thousands of CDOs on the same shaky bond. When that bond defaulted they did not have to pay the value of the bond but that value times the number of CDOs they sold against it.
Goodbye Bear Sterns.
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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Tue 29 Dec 2020, 23:00:34

vtsnowedin wrote:Wow an eleven year gap in a thread!!
My problem with CDS is this. You can insure your house for fire or other loss but not your neighbors or that crack house down the street.
They allow you to buy a CDS against bonds you did not write or own.
That made it a casino where betters could place bets on any unsound instrument they thought would default and banks sold hundreds or even thousands of CDOs on the same shaky bond. When that bond defaulted they did not have to pay the value of the bond but that value times the number of CDOs they sold against it.
Goodbye Bear Sterns.

And owning stock shares in a company you don't work for lets you gain profits, if say, AAPL products do well. And yet that has been FINE for hundreds of years, re common stock.

Do you actually have a point, or do you just enjoy whining? Hint: as technology changes, MANY things that weren't possible before are possible now. For example, stock options only started trading on exchanges in standard contracts, producing significant trading markets in 1974. I make almost all my active stock (or derivative) trading money in options selling weekly or monthly option theta against longer term options (i.e. calendar spreads) -- see option Greeks for a definition of theta re options.

And liberals will say that's "unfair" since I worked my way through calculus in college (supposedly "privelege", even though I earned an academic scholarship and WORKED to earn the room and board), so I actually understand the math I need, behind options. And yet, technology lets MANY things produce results for LOTS of people that were unimaginable before -- see many aspects of electronics, for example.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Thu 31 Dec 2020, 09:13:06

If you buy shares in a company you have skin in the game so of course you are entitled to make a profit. A CDS is for the owner of the bond an insurance policy but for anyone other then the bond holder it is just a bet and that can and has lead to disaster.
Ask the former employees of Bear Sterns.
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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Mon 04 Jan 2021, 21:55:32

vtsnowedin wrote:If you buy shares in a company you have skin in the game so of course you are entitled to make a profit. A CDS is for the owner of the bond an insurance policy but for anyone other then the bond holder it is just a bet and that can and has lead to disaster.
Ask the former employees of Bear Sterns.

Guess what. For most of the options I am in calendar spreads with, I own little or NO underlying stock (unless that is accidentally in the passive mutual funds I own for decades at a time (and don't trade for decades at a time).

Now, show how derivatives are somehow "unfair" or "invalid", given that they're covered by legal contracts, require plenty of margin up front, etc. -- then by all means demonstrate that.

Hint: whining emotionally like Bernie Sanders or Liz Warren is NOT a valid demonstration.

And by the way, when I get hurt on a position for a time (and that happens -- anyone who claims it doesn't is a pure bullshitter), I don't complain that it's not fair, blame the fates, etc.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Tue 05 Jan 2021, 11:13:44

Outcast_Searcher wrote:
vtsnowedin wrote:If you buy shares in a company you have skin in the game so of course you are entitled to make a profit. A CDS is for the owner of the bond an insurance policy but for anyone other then the bond holder it is just a bet and that can and has lead to disaster.
Ask the former employees of Bear Sterns.

Guess what. For most of the options I am in calendar spreads with, I own little or NO underlying stock (unless that is accidentally in the passive mutual funds I own for decades at a time (and don't trade for decades at a time).

Now, show how derivatives are somehow "unfair" or "invalid", given that they're covered by legal contracts, require plenty of margin up front, etc. -- then by all means demonstrate that.

Hint: whining emotionally like Bernie Sanders or Liz Warren is NOT a valid demonstration.

And by the way, when I get hurt on a position for a time (and that happens -- anyone who claims it doesn't is a pure bullshitter), I don't complain that it's not fair, blame the fates, etc.

I am not whining about anything and I care not a bit about your investments in CDSs.
I merely explained why I think they are mathematically unsound when sold to none holders of the insured securities.
I think that is a risk that is unsound and firms would be unwise to sell them even if legal. But of course that is only my layman's opinion and nobody in charge asked me for it.
The casino is open, place your bets gentlemen.!
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Re: Credit Default Swaps

Unread postby billybell » Thu 20 Jan 2022, 10:10:21

The Big Short is easily my favorite finance-related movie of all time and I had to watch it multiple times to understand this concept....After years, I can finally say that I’ve understood the concept..
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Re: Credit Default Swaps

Unread postby Doly » Thu 20 Jan 2022, 15:52:34

If you buy shares in a company you have skin in the game so of course you are entitled to make a profit.


Do you really have a lot of skin in the game these days? When public companies are all about keeping shareholders happy, above just about anybody else? And selling shares is the easiest thing in the world?

Let's put it this way: Imagine you are allowed to bet in a casino, but this casino doesn't just use the money of the people who place bets to run. This casino is allowed to syphon out money from other places as well, which means on average you tend to win more often than lose. And the casino prefers to keep customers happy over all the other people it's syphoning money from. Also, you can stop betting any time you like. Would you call risking your money on that casino having skin in the game, or just playing something that's both fun and profitable?
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Re: Credit Default Swaps

Unread postby vtsnowedin » Fri 21 Jan 2022, 07:42:58

Doly wrote:
If you buy shares in a company you have skin in the game so of course you are entitled to make a profit.


Do you really have a lot of skin in the game these days? When public companies are all about keeping shareholders happy, above just about anybody else? And selling shares is the easiest thing in the world?

Easy? well you do have to own shares to sell them or be able to cover your bets if you sell short. Have you watched the Robinhood/ Gamestop players this year?
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Re: Credit Default Swaps

Unread postby Doly » Fri 21 Jan 2022, 14:26:57

Easy? well you do have to own shares to sell them or be able to cover your bets if you sell short. Have you watched the Robinhood/ Gamestop players this year?


I'm roughly aware of those shenanigans, though not in detail. Sure, if you bet more than you have, you can get really burnt. But that applies to any kind of bet. My point was, some bets are intrinsically safer than others, and some are so safe that they can hardly be called "having skin in the game".
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Re: Credit Default Swaps

Unread postby theluckycountry » Tue 12 Apr 2022, 04:36:32

Amazons share price is over $3000, nice if you bought in back in the 00's. It also has $50 Billion in outstanding bonds, think about that for a second. Why would a company that's so successful want carry such an enormous amount of debt? These are unsecured bonds too, so god help anyone who owns them if the internet every goes down and Amazons crashes. But we know why they have taken on the debt, Growth, cornering the market, and they are adding more to this pile, another $12 billion, due to what the spin doctors claim is huge demand from investors. I can imagine who those investors are too, the big hedge funds and private pension funds who really don't give a toss if the money is eventually lost.

For a person like me who can't afford to lose a big chunk of his life savings it would be insane to invest in these instruments, and why for that matter is Amazon issuing them? To pay for huge share buybacks that they undertook to stabilize their share price. It's all a big bullshit casino and those playing at the tables are smiling now but they weren't back in 2008 I can assure you. This will all unwind again soon no doubt and trillions will be lost.

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Re: Credit Default Swaps

Unread postby vtsnowedin » Tue 12 Apr 2022, 07:40:58

Low and even zero interest rates let companies borrow cheap as long as they could do anything profitable with the money. Now higher interest rates will change the math and those low interest bonds will get paid off not just rolled over.
And when you think about it fifty billion in bonds is not much for a company capitalized at 1.54 trillion.
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Re: Credit Default Swaps

Unread postby theluckycountry » Wed 13 Apr 2022, 07:52:05

The capitalization is based on the share price, which is based on peoples perceptions, which are based on emotions for the most part. Amazon is just another stock caught up in the biggest mania of all time, it could fall by 80% in a week but the debt would still be there. The only people who are staring at this bubble yet can't see it are the ones actively investing in it. Little day traders.

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Re: Credit Default Swaps

Unread postby vtsnowedin » Wed 13 Apr 2022, 08:15:01

While Amazon is over priced at 46X earnings it does have real profits which are growing so it becomes less speculative as time goes on. The five year average was 113X earnings so it and the rest of the market segment are improving or at least they have been. The question is, How will it fair in inflationary times with a recession thrown in? Considering it's share of the market and customer base I expect that it will do better then most of it's competition.
That said I only buy it through index funds preferring to place individual stock bets on dividend paying stocks with much lower P/E ratios.
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Re: Credit Default Swaps

Unread postby Doly » Thu 14 Apr 2022, 15:42:17

While Amazon is over priced at 46X earnings it does have real profits which are growing so it becomes less speculative as time goes on. The five year average was 113X earnings so it and the rest of the market segment are improving or at least they have been. The question is, How will it fair in inflationary times with a recession thrown in?


The main competitor of Amazon are brick-and-mortar stores. With gas prices going up, people will reduce their shopping trips, which probably means more business for Amazon.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Thu 14 Apr 2022, 17:53:02

Doly wrote:
While Amazon is over priced at 46X earnings it does have real profits which are growing so it becomes less speculative as time goes on. The five year average was 113X earnings so it and the rest of the market segment are improving or at least they have been. The question is, How will it fair in inflationary times with a recession thrown in?


The main competitor of Amazon are brick-and-mortar stores. With gas prices going up, people will reduce their shopping trips, which probably means more business for Amazon.

Perhaps but everything Amazon sells has to be delivered to the buyer. While drone deliveries maybe practical in urban and dense suburban areas, rural areas like my home are out of that range. I currently see a UPS or FedEx truck on average of once a day and during the Christmas shopping season a couple of visits each. That takes a lot of gas and that fuel cost has to be passed onto the customer. If gas gets above $6.00/gal. I suspect they will want you to pick up your purchases once a week when you are out anyway doing your grocery shopping.
The delivery companies of course don't want to limit delivery days or cooperate with their competitor or heaven forbid take yours going to the west side of town and take mine going to the east and call it even but high fuel prices may force them to it.
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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Sat 16 Apr 2022, 21:35:03

vtsnowedin wrote: I am not whining about anything and I care not a bit about your investments in CDSs.
I merely explained why I think they are mathematically unsound when sold to none holders of the insured securities.
I think that is a risk that is unsound and firms would be unwise to sell them even if legal. But of course that is only my layman's opinion and nobody in charge asked me for it.
The casino is open, place your bets gentlemen.!

My bad re the whining (causing a misunderstanding there -- all my fault the way I put that). I'm talking about much of the left whining about people making profits on complex investments and calling that "unfair", citing Liz Warren and Bernie Sanders as flagrant examples. I'm not saying you're whining about it.

And to be clear, I have no CDS's and never have. I've never much liked debt, whether being in debt or owning debt, especially long term debt. So not only do I eschew things like CDS's, I avoid bonds over about 7 years from maturity as well. Since about the mid-80's, given the interest rates, I just don't like the risk/reward. At least with stocks, if the company goes well you can get a really big payoff for risking your capital. With bonds, you hope to get your principal and interest back, and not get raped by taxes and inflation. Until interest rates went to zero, I actually loved high quality (i.e. treasury) money market funds given the risk/reward ratios and interest rates. I'm actually hoping that IF inflation stays with us for years, we get back to a world where short term interest rates roughly mirror inflation rates, and savers like me can at least get paid to compensate for inflation (before taxes), but I'm not holding my breath on that.

I'm simply not in agreement with you that not owning the underlying investment makes it "mathematically unsound" for CDS's, as though CDS's are somehow unique re that risk/reward concept. Of course, you're welcome to have that opinion and express it -- I just think you're dead wrong. Obvious examples:

1). Virtually every speculator (as opposed to big business hedging production or consumption of commodity X for their business) in commodities isn't a manufacturer or big user of the commodity. They're just betting on the movement in the commodity price. Especially those only betting on the options, and there are PLENTY of commodity option contracts. The commodities markets are HUGE, and much of the big business hedging relies on them, both for sellers of commodity goods, and buyers of those goods. (Example: Oil company and airline, for the crude oil commodity).

2). As I said, for stock options where one doesn't own the stock, same thing. The stock options market is now GIGANTIC, re total volume of contracts traded, and total notional value of all the contracts outstanding at any point in time. Especially in modern speculative times, MANY people trade options because they can't "afford" to own the underlying stock. There are MANY courses on how to do this on Youtube videos. (And I don't think it ends well, but it's quite normal).

3). The FX (foreign exchange) markets, re trading currencies. Today one can easily be net long or short virtually any basket of currencies they wish, all the time. (Which is why I think the whole idea of the US dollar being the "reserve currency" is largely obsolete, re practicality). So same deal there. With FX options you can make wild and massive bets on any currency you want, while owning NONE of it.

So I just think you looking at CDS's as somehow a unique thing that should require ownership in the underlying debt is unrealistic in the modern world. That's why there are financial clearing houses, strict margin requirements, and lots of regulations. To try and protect the system against the risk. And of course, that works fine -- until it doesn't, as we saw during the great recession.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Sun 17 Apr 2022, 04:31:25

1). Virtually every speculator (as opposed to big business hedging production or consumption of commodity X for their business) in commodities isn't a manufacturer or big user of the commodity. They're just betting on the movement in the commodity price. Especially those only betting on the options, and there are PLENTY of commodity option contracts. The commodities markets are HUGE, and much of the big business hedging relies on them, both for sellers of commodity goods, and buyers of those goods. (Example: Oil company and airline, for the crude oil commodity).

I am an investor not a speculator and that forms my opinions about all forms of speculation. Yes those markets are huge and legal but so are the casinos in Macau.
I choose not to just gamble in any form and even if I only have $100 would rather actually own a fractional share of a real profit making company then a option or a hedge or anything else they make complicated enough so the brokerages have the same odds of taking your money as a Vegas casino.
A lot of people assume they are smarter then the average Joe and are sophisticated enough to win big in the speculation markets. I except that I am not likely to be above average and will settle for the simple market average I understand.
Your results might vary. :)
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