Credit default swaps (CDS) intro | Finance & Capital Markets | Khan Academy

Credit default swaps (CDS) intro | Finance & Capital Markets | Khan Academy

Let’s say that I run some
type of a pension fund, and I have $1 billion that
I need to invest someplace. And I dig around a
little bit, and there’s this Company A over
here, and it needs to borrow a billion
dollars, and it’s willing to give 10%
interest in exchange for borrowing that
billion dollars. So if I give these
characters over here my billion dollars, if I lend
it to them, if I lend them the billion dollars,
on an annual basis, they’re going to
give me 10% interest. There’s a problem here though. The rating agencies, the
ones that in theory should be independent, they’ve only
given Company A a BB rating. And this is a pension fund. I have to only invest in the
safest of safest of securities. I have to invest only
in things that are AA. And so here might enter
a character like AIG, and obviously things have
changed since their heyday. But AIG, based on at
least Moody’s perspective, has a AA rating. So AIG could say, hey, look
pension fund, why don’t you lend them the money,
and what we’re going to do is enter into
a credit default swap. And what that essentially
is, is a form of insurance. Of that 10% every year, why
don’t you give us 1% of that? And in financial
lingo, that’s sometimes referred to as 100 basis points. And in exchange for that, in
exchange for that 100 basis points a year, you could view
this as the insurance premium, we are going to ensure
that if for whatever reason Company A defaults on that
debt, you can give us the debt, you can give us
that debt security, and we will just give you
back your billion dollars. Now from the pension’s point of
view, this sounds pretty good. They’re now getting a net 9%
of interest, 10% minus the 1%. And they’re essentially getting
to lend to a BB company, but it’s in effect
like lending to a AA, because as long as AIG
is good for the money, then the pension fund is
going to get their money back one way or the other. Now where this gets
a little bit shady is AIG right here didn’t
have to do anything. What’s interesting about
credit default swaps– credit default swaps
sometimes referred to as CDSs– is that even
though they are insurance, for all purposes
they are insurance, they are not regulated
like insurance. So typically an
insurance company when they insure
something, they have to set aside some money, in case
that thing actually happens. And they have to work out the
probabilities and all of that. Credit default swaps were
not regulated in that way. So AIG could do
this without having to set aside any type of money. And they could do
this over and over and over and over again,
kind of snowballing all of their
potential liabilities. And so you could imagine,
it’s really good money while no one is
defaulting, but all of a sudden when people
start defaulting, then all of a sudden AIG is
going to be in trouble. And all the people who
thought they had, in effect, AA debt because AIG was
insuring it, might not.

29 thoughts on “Credit default swaps (CDS) intro | Finance & Capital Markets | Khan Academy

  1. Actually, AIG knew those CDS were backed- by the US tax payer. They collected the cash, took the bonuses, then sacked the tax payer for the loses.
    No one went to jail.
    And the banks are right back leveraged up again and taking in record bonuses.
    Banks have been doing this for hundreds of years. Privatize the gains and shift the loses to the tax payer. ..they just have increased the scale, are more brazen, and have more political influence.

  2. Unluckily, most people don't understand the value added by financial markets, nor do they understand the real problems. That's one of the things why our chancellor Merkel does her current egg-dancing: Keeping uninformed masses happy enough so that she can get on with the real work.

  3. @DavidAKZ please reframe that request. I don't assume you think that a system that works extremely well must never fail sometimes…. If you mean where the value added of financial markets as a whole lies, try to experiment with the "gambler's ruin" idea, ideally with Monte Carlo simulations and learn why accurate risk assessment is crucial for even the most basic growth curves.

  4. @SalsaTiger83 I'm not sure the quantification of risk is important to criminals.
    Greenspan Admission

  5. @DavidAKZ Funny, he actually says there was some fraud in the past (Duh…) … but if you want to stay ignorant and poor, you're welcome… I think communism failed every time because they didn't get corruption or risk management right, especially not in agriculture, where it is most obvious that you need solid risk forecasting.

  6. @SalsaTiger83 in financialised futures markets (agriculture for example) where you can borrow an infinite supply of $ @ 0.25% – risk management is for peasants. Do you think the price of wheat has doubled in a year because of supply and demand fundamentals ?
    The Wicked Witch Is Nervous (Google Blythe Masters)

  7. @DavidAKZ You're arguments are very fuzzy, care to elaborate or be more specific? Financial prices are random walks. And yes, price doubling because of randomly changing public information of basic supply and demand fundamentals is quite possible, especially if you factor in complex systems theory. I don't disagree, markets have to be regulated a lot more, but people just don't understand. You apply hate and ignorance to a problem that needs deeper understanding.

  8. are this video and the one about CDOs inspired by a reading of Michael Lewis' The Big Short? i read it in the spring and half the book seemed to be either "credit default swaps" or "CDOs"

  9. you said that u gave $1B to company A for 10% interest a year, but u havent said for how long, if its for 10 years it wouldn't make any sense, should it be more than 10 years obligation?

  10. Well isnt this how the recession of 2008-09 started. AIG selling CDS on home mortgages by changing their credit ratings ? As long as the payments on loan was happening. The pension fund kept on receiving interest. The moment the loan payments were defaulted. Majority of problem started happening.

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