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This article may be from the Wharton School, and it may be edited or excerpted in some way, but it does not give a clear explanation of what a credit default swap is.

It describes a CDS as a bet. This is false.

Let me explain first what a CDS is.

It is a contract which states that in the event of a default on a "reference obligation" (which depends on the contract: the reference obligation could be bank indebtedness, corporate bonds, debentures, etc.) of a company, then the buyer of the contract is entitled to a certain payment from the writer (seller) of the contract upon delivery of the reference obligation.

Let me give an example.

Widget Corp issues $100MM senior unsecured bonds. Alice believes that there is a risk of default on these bonds - that Widget will go bankrupt and be unable to pay interest or principal on the bonds. So Alice goes to Bob - a trader who writes CDS - and purchases $10MM of CDS on Widget.

Other investors feel the same as Alice does and Bob eventually writes 200MM of CDS on this 100MM bond issue.

Widget defaults. The bonds trade down to a level where they are selling at 10 cents on the dollar.

Alice decides to cash in her CDS contract. In order to do this, she needs to deliver the reference obligation - she needs to get $10MM face value of Widget bonds so that she can deliver them to Bob, so Bob will be required to pay her the $10MM.

So Alice goes into the open market to buy $10MM face value of Widget bonds at 10 cents on the dollar - in other words $1MM in market value of Widget bonds.

However, there are individuals who hold $200MM of Widget CDS and only $100MM in bonds to fulfill the reference obligation.

This means that CDS holders will bid up the bonds from 10 cents on the dollar up to a higher level until the CDS contract has no more inherent value.

What has this done? It has had the effect of spreading risk much more evenly around the market that would have happened otherwise.

Let's dig deeper for a moment. Why would Alice buy CDS in the first place? Is she a gambler, making a bet? hardly. Alice, like almost all buyers of CDS, is a portfolio manager attempting to use CDS as a tool.

For example, she could be a manager of a convertible arbitrage fund.

many companies issue convertible debt. This is a bond which acts like a normal bond but can be exchanged for a certain number of shares of the company's stock.

So if a company issues a $1000 bond which is convertible into 10 shares of the stock, as long as the stock is below $100 a share and the company's credit is good, the bond will trade in the neighborhood of "par" or its $1000 face value.

However, if the stock shoots up to $150 per share, that bond may trade up to $1500 in the market.

So basically a convertible is a bond that comes with a call option on the stock.

Alice can remove the equity risk to her bond caused by fluctuations (volatility) in the shares by shorting shares of the stock. If she could also remove the credit risk in the bonds by selling short that risk, she would be able to eliminate both the equity and the credit risk in the bond and be able to get a return based solely on the volatility of the stock and the credit.

This is one example of what is known as a "market neutral" strategy.

Well, there is a large market out there for equity options, and there is also a large market out there for credit options (CDS contracts).

They are not normally used by investors as bets, but as risk management tools.

Very few people seem to be worried about the enormous volume of sales of naked equity options (people selling naked calls, for example, as well as far more exotic equity options) but everyone seems to be have fainting spells over naked CDS.

It's irrational and uninformed.

Why do you object to the term “bet”? All investments are bets. Some are better bets on others. But anything with a risk/reward scenario is a bet.

So I have no problem with referring to CDS as a bet.

bttt

Thanks for the info, you two!

Self ping for when my brain's working better...

The ideal world sounds nice, but you should add few real world scenarios. Bob issues CDS on BuggywhipCorpX and BuggywhipCorpY. Both default due to an unforeseen inventions, Bob only expected one or the other to default and Bob runs out of money. Govt bails Bob out.

Bob uses his "AAA" from other parts of his business to obtain credit lines for the CDS. Sam wants to compete with Bob but with his more expensive credit lines, Sam changes his default assumptions and offers the same or better price for his CDS as Bob (there are no regulations on them). Sam ultimately defaults on the CDS he issued.

Bob prices CDS assuming there would not be a recession. Alice thinks there will be recession and buys lots of Bob's and other issuers' CDS as a speculative investment. In one case there is a recession, Bob is out of money, govt bails him out. In another case there is no recession, but Alice is unable to pay her CDS obligations and Bob is forced to write them off leading Alice to default on her obligations in a systemic meltdown.

This article may be from the Wharton School, and it may be edited or excerpted in some way, but it does not give a clear explanation of what a credit default swap is. It describes a CDS as a bet. This is false.

You need to read the WHOLE lesson (bad student... ;-)). If you did, then you would have learned that the referenced article is broken down into 3 lessons. The second lesson is all about Credit Default Swaps.

Stay tuned...

Thanks for the explanation.

Isn't the problem here the degree of leverage here? Am I correct in thinking that in your example the Widget bonds are leveraged 2:1? That is that there have been 200MM in CDS for 100MM in bonds. When Widget goes bankrupt it's going to be like musical chairs and a bunch of somebodies - indeed half the total investment in the CDS are going to be unable to get the bonds and get no return. I read that some of these large firms are leveraged by 40:1 and up to 80:1. If I am looking at this when a highly leveraged CDS goes, a lot of the investors lose.

Now, is this not precisely what they signed up for when they bought this crap? Shouldn't they just take their losses and learn from their mistakes?

Where I get angry is when there is real abuse and big piles of this stinking mess are tranched and then these pieces are further split and bundled and all of a sudden you have some real stinkers is SPVs that ratings that are far higher than their real risk. Here the investors lose but the bundlers and the raters have committed fraud. Should we not see lots of these wise-guys pay some hefty fines and do some significant jail time?

Please correct any misconceptions you detect. I want to understand this properly and that means quantitatively.

Wideawake: Great description... Thanks!

Question though... You said, “Other investors feel the same as Alice does and Bob eventually writes 200MM of CDS on this 100MM bond issue.”

Wouldn’t there only be a one-to-one mapping between the amount of actual bond issue (100MM) and the amount of CDS “open interest” (to use stock option parlance)?

In other words, why would there be a market for more CDS’s than there is bond issuance? Wouldn’t only people buying the bonds want this kind of insurance?

Or is it like the stock options market where you might simply have bettors who think there is a good chance that Widget Inc. will go belly up?

Thanks in advance for your response...