How Credit Default Swaps Differ from Insurance and Bets
Summary
The note explains why a credit default swap can resemble a bet while serving as a credit-risk transfer instrument. A bondholder or other party exposed to a company’s credit risk can pay a premium to a protection seller, who owes compensation if a defined credit event occurs. The contract therefore allows the buyer to reduce potential losses from a borrower’s default or another specified event.
The answer distinguishes CDS from typical insurance in two ways: buyers generally do not need to own the referenced bond, and CDS contracts can be traded over the counter among dealers and end users. Without an underlying exposure, buying protection amounts economically to taking a view on the company’s credit outcome, which motivates the comparison to betting. The discussion is conceptual and does not detail contract terms, settlement mechanics, regulation, or the precise range of events that may qualify as credit events.
Key ideas
- A CDS transfers specified credit risk from its buyer to its protection seller in exchange for a premium.
- CDS protection can be purchased without owning the referenced bond.
- Unlike most insurance, CDS contracts are traded over the counter between market participants.
- A CDS buyer without exposure to the reference entity is taking a position on its credit outcome.
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# What is the Difference Between a Credit Default Swap and a Bet # What is the Difference Between a Credit Default Swap and a Bet Reading the wikipedia page for derivatives on 00:02 E.S.T March 21 2016, a credit default swap (CDS) is summarized as being "A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event", and goes on to say "It was invented by Blythe Masters from JP Morgan in 1994". To a layman like me, this sounds very similar to a bet, and so it seems weird to say this concept was invented in 1994. In what way is a "credit event" distinct from something like a gambling event (like a dice roll or horse race)? Could the credit event be a person losing a bet that party A would win in game X? ## Answer by Neeraj (score 4, accepted) https://quant.stackexchange.com/a/25007 The basic idea behind the CDS to provide protection from credit risk to the buyers of corporate bond. They are supposed to be like a insurance product where he buyer of the CDS pay the premium to the seller for the repayment of principle amount if company gets defaulted. But CDS are different from insurance product in two ways. As pointed by Stulz (2010) > However, the parallel between insurance contracts and credit default swaps does not hold in two important ways. First, you do not have to hold the bonds to buy a credit default swap on that bond, whereas with an insurance contract, you typically have a direct economic exposure to obtain insurance. Second, insurance contracts (mostly) are not traded; in contrast, credit default swap contracts do trade over the counter—that is, a market where traders in different locations communicate and make deals by phone and through electronic messages. Dealers trade with end users as well as with other dealers. So, buying CDS without having direct exposure to the company bond is like betting on the fortune of the company.
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