BASIC CONCEPTS TO UNDERSTAND CDS

A foreign exchange market is the one where one currency (foreign currency) is bought & sold against another currency (domestic or home currency). The transaction in the foreign exchange market can be either exchange of cash or to buy/sell some other instruments, like currency forward, currency futures, currency options & currency swaps.

CERTAIN TERMS OF FOREIGN EXCHANGE

Spot transactions refer to the transactions involving sale & purchase of currencies for immediate delivery. Currency forward contracts are settled on a future date even though the forward rates are quoted at present moment (or today). They are quoted just like spot rate but actual delivery of currencies takes place much later.

Yet. Currency options are the instruments that give choice to their holder to buy or sell a foreign currency on or up to a date (also called maturity date) at a specified exchange rate (also called strike rate). OPTIONS & SWAPS Currency futures are conceptually similar to currency forward. .CURRENCY FUTURES. they are distinctly different from the latter in terms of their quotations & dealing.

Speculators..BASIC TERMS«. . Arbitraguers. Participants in the Foreign Exchange Market are Central Banks. Commercial Banks. Foreign Exchange Brokers. Arbitraguers profit by discovering price differences between pairs of currencies at different dealers or banks. Swaps are the instruments that enable two parties to exchange the stream of cash flows in two different currencies.

They participate in the market to make a gain which results from an unanticipated change in exchange rate.ARBITRAGE & SPECULATION Arbitrageurs are those operators on the foreign exchange market who search for rice discrepancies & make profit by buying cheap from one dealer & selling dear to another. . We can define arbitrage as the process of making risk-less profits by intelligently exploiting price difference of a asset at different dealing places. Bulls expect that a currency is going to appreciate in near future. Speculators can be either bulls or bears. Speculators are deliberate risk-takers. An open position in a foreign currency is speculation.

DERIVATIVES Derivative is an instrument that derives its value from another underlying asset or rate. options & swaps. The common derivatives are futures. Derivative product is created by the introduction of a new security having a relationship with the underlying cash or spot market. Without the underlying asset. a derivative would have no independent existence or value. .

Futures contracts exist in commodities. A futures contract is an agreement to make or take delivery of a specified quantity at an agreed price on a future date in the underlying market.DERIVATIVES«. . interest rates & currencies. equity indices. An option is a right but not an obligation to make or take delivery of a specified quantity of an underlying asset at an agreed price on a future date. equities.

receives a payoff if a credit instrument - . in exchange.CREDIT DEFAULT SWAP A CDS is a swap contract in which the buyer of the CDS makes a series of payments to the seller and.

CDS «. according to the ISDA (International Swaps & Derivative Association ² over twice the size of the U. . the value of the market had ballooned to an estimated 45 trillion dollars. The first CDS contract was introduced by J.P. stock market. CDS are the most widely used type of credit derivatives and a powerful force in the world markets. Morgan in 1997 and by mid 2007.S..

MBS or corporate debt between two parties.CDS ² HOW THEY WORK A CDS contract involves the transfer of the credit risk of municipal bonds. It is similar to Insurance because it provides the buyer of the contract. who often owns the underlying credit. with protection against default. emerging market bonds. . a credit rating downgrade or another negative credit event.

instead reference it. .CDS ² HOW IT WORKS The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee. the Bond involved in the transaction is called the reference obligation. similar to insurance premium and is obligated to pay only if a negative credit event occurs. For this reason. It is actually important to note that the CDS contract is not actually tied to a bond.

because the buyer pays a premium. .CDS ‡ Typically a bond or loan ² goes into default (fails to pay). and in return. the credit event that triggers the payoff can be a company undergoing restructuring. Less commonly. receives a sum of money if one of the events specified in the contract occurs. ‡ CDS contracts have been compared with insurance. bankruptcy or even just having its credit rating downgraded.

‡ ‡ . to purchase insurance.CDS Vs. INSURANCE ‡ There are a number of differences between CDS & Insurance. The seller need not be a regulated entity. the insured is generally expected to have an insurable interest such as owning a debt obligation. for example : The buyer of a CDS does not need to own the underlying security or other form of credit exposure. in fact the buyer does not even have to suffer a loss from the default event. In contrast.

while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers & transactions in underlying bond markets. ‡ Insurers manage risk primarily by setting loss reserves based on the Law of large numbers. although major CDS dealers are subject to bank capital requirements.Difference between CDS & Insurance ‡ The seller is not required to maintain any reserves to pay off buyers. .

. In the United States CDS contracts are generally subject to mark to market accounting. In practice this rarely happens. introducing income statement & balance sheet volatility that would not be present in an insurance contract. Hedge accounting may not be available under US GAAP unless the requirements of FAS 133 are met.CDS ««.

Also these contracts are really default options NOT SWAPS. . The main difference from a regular option is that the cost of the option is paid in installments instead of upfront.CDS In a CDS contract. a protection buyer(say A) pays a premium to the protection seller(say B) in exchange for payment if a credit event occurs. Counter Party A Protection buyer Periodic Payment Contingent Payment Counter Party B Protection Seller Reference : Asset Bond This Contract represents the purest form of credit derivatives as they are not affected by fluctuations in market values as long as the credit event does not occur. The contingent payment is triggered by a credit event (CE) on the underlying credit. these contracts are called Default Put Options. When the premium is paid upfront. The premium in payment can be a lump sum or periodic.

. If the company defaults the final pay off will be the same. Default Swaps are embedded in many financial products. which now trades at 40 cents on the dollar.000 to the protection seller. The upfront cost is the same $ 90.EXAMPLE The protection buyer.µ At the beginning of the year. Say. A pays $ 5. The bond is called ´CREDIT ASSET. If A holds this bond in its portfolio the CDS provides protection against credit loss due to default. for instance that the risky bond sells at $ 90 and promises to pay $ 100 in one year.00. Company XYZ defaults on this bond. The counterparty then has to pay $ 60 million to A. The swap entails on annual payment of 50 lap. The risk free bond sells at $ 95 and selling a CDS worth $ 5 now. Investing in a risky (credit sensitive) bond is equivalent to investing in a risk-free bond plus selling a CDS. call it A enters 1 year CDS on a Notional of $ 100 million worth of 10 year bonds issued by XYZ. Say that at the end of the year.

These firms needed a cash infusion due to losses resulting from mismanagement and the subprime mortgage crisis. Some of them have grabbed attention making bad investment in several Wall Street financial firms including Citigroup. It is basically global funds. . property.SOVEREIGN WEALTH FUND It is a state owned investment fund composed of financial assets such as stocks. precious metals or other financial instruments. Morgan Stanley and Merrill Lynch. bonds.

which accumulates the funds in the course of its management of a nation·s banking system. . which are usually of major economic and fiscal importance. Other sovereign wealth funds are simply the state savings which are invested by various entities for the purposes of investment return and which may not have a significant role in fiscal management.Sovereign Wealth Fund Some of them are held solely by a Central bank.

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