Felix wrote:mvscal wrote:
You bet. If it happens on your watch, it's your fault
while earlier in the thread
mvscal wrote:which branch of government has the responsibility for regulating or failing to regulate credit default swaps
given that a Republican congress was in control at the time that CDS's came into existence, coupled with the fact that you yourself indicated that the congress is responsible for oversight of the CDS, then I think it's pretty evident who was ultimately responsible...
it was Jimmy Carter's fault
This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of N(1 − R) shown in red, where R is the recovery rate, or it survives without a default being triggered, in which case a premium payment of Nc / 4 is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.
The probability of surviving over the interval ti − 1 to ti without a default payment is pi and the probability of a default being triggered is 1 − pi. The calculation of present value, given discount factors of δ1 to δ4 is then
Description Premium Payment PV Default Payment PV Probability
Default at time t1 0\, N(1-R) \delta_1\, 1-p_1\,
Default at time t2 -\frac{Nc}{4} \delta_1 N(1-R) \delta_2\, p_1(1-p_2)\,
Default at time t3 -\frac{Nc}{4}(\delta_1 + \delta_2) N(1-R) \delta_3\, p_1 p_2 (1-p_3)\,
Default at time t4 -\frac{Nc}{4}(\delta_1 + \delta_2 + \delta_3) N(1-R) \delta_4\, p_1 p_2 p_3 (1-p_4)\,
No defaults -\frac{Nc}{4} ( \delta_1 + \delta_2 + \delta_3 + \delta_4 ) 0\, p_1 \times p_2 \times p_3 \times p_4
To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give
PV\, =\, (1 - p_1) N(1-R) \delta_1\,
+ p_1 ( 1 - p_2 ) [ N(1-R) \delta_2 - \frac{Nc}{4} \delta_1 ]
+p_1 p_2 ( 1 - p_3 ) [ N(1-R) \delta_3 - \frac{Nc}{4} (\delta_1 + \delta_2) ]
+p_1 p_2 p_3 (1 - p_4) [ N(1-R) \delta_4 - \frac{Nc}{4} (\delta_1 + \delta_2 + \delta_3) ]
-p_1 p_2 p_3 p_4 ( \delta_1 + \delta_2 + \delta_3 + \delta_4 ) \frac{Nc}{4}
Hedging
Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.
For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage the risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million that trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the pension fund, its risk of loss due to Risky Corporation defaulting on the bond is eliminated. (However, the fund still faces counterparty risk if Derivative Bank becomes insolvent and cannot honor the CDS contract). If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.
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vote for Nogga, he'll 'plain it to you.
