Wednesday, November 12, 2008

Credit Swaps

What are credit swaps? ( This word has been mentioned quite a lot of times in this financial crisis)


Credit Default Swaps (CDS) is an insurance against a default of a bond. Where you can actually can own or not own that bond.

In short

It is something like paying an insurance premium to company A betting that company B will fall.

A scenario example will be : An investor like me pays company A $2 every year, because in the event company B fails, I will get $50. This premium drops when company B is supposedly reputable and reliable because it unlikely to fail.

However in the case of AIG ( company A) , because large reputable companies ( comapany B = Lehman Brothers etc.) fell, they had to pay these investors huge sums of money and hence was almost forced to bankruptcy.

Hope you all understand a little more about CDS now.. =)