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Brief Introduction to Credit Default Swaps

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Credit Default Swaps. Cash Flows on Bond CDS. Principal. Coupon - CDS Premium. Principal ... CDS Seller will default) Credit Default Swaps. Some Dangers ... – PowerPoint PPT presentation

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Title: Brief Introduction to Credit Default Swaps


1
Brief Introduction toCredit Default Swaps
2
Credit Default SwapsBig Picture
  • Credit default swaps neutralize credit risk
  • This gives asset managers the flexibility to
    hedge and optimize their risk profile

Asset Without Credit Risk
Risky Bond Asset
Credit Default Swap

3
Credit Default SwapsExpected Cash Flows on Bond
These payments are subject to credit risk (the
danger that
the issuer may default)
Principal
Payments to Holder by Issuer
. . .
Coupon
Coupon
Coupon
Principal
Payments to Issuer by Holder
4
Credit Default SwapsCash Flows on CDS
. . .
Premium
Premium
Premium
Payments from Holder to CDS Seller
No default occurs (high probability)
Notional (Principal)
Payments from CDS Seller to Holder
Default occurs (low probability)
. . .
Premium
Premium
Payments from Holder to CDS Seller
5
Credit Default SwapsCash Flows on Bond CDS
No credit risk in these payments
Principal
Net payments to Holder by Issuer and CDS Selle
r
. . .
Coupon - CDS Premium
Coupon - CDS Premium
Coupon - CDS Premium
Principal
Payments to Issuer by Holder
There is counterparty risk, however (the risk th
at the
CDS Seller will default)
6
Credit Default SwapsSome Dangers
  • Pricing assumes a particular probability that
    default will occur
  • If it is gauged too low, the CDS Seller may have
    losses
  • Default probabilities across bonds interact and
    are correlated
  • If this is misgauged, a CDS Seller with multiple
    exposures may have losses
  • AIG, for example, had large unhedged CDS
    exposures across many bonds
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