#creditdefaultswap #thebigshort #wallstreetbets

Credit default swap or CDS is a financial derivative that allows the holder of swapping the credit risk over a certain credit financial instrument with the counterpart they dealt the CDS with. For example if you fear that a certain bond or any credit financial risk might not be able to back what it owes in the future, you might buy a credit default swap in order to unload this risk on a counterpart. Given that many debt financial instruments have a very long lifetime, even 30 or 50 years, it’s hard to understand the underlying risk that the asset will face during this long time.
So Credit Default Swaps are great instruments in order to manage this risk over the long term.
In order to have this instrument you’ll have to pay an upfront fee and reoccurring payments during the whole duration of the contract. On the other side, the seller of the CDS agrees that, in case the debt issuer of the financial instrument fails to fulfill its obbligations of paying back the full value of the instrument plus the interests, the CDS seller will make up for that to the buyer.

When we think about these instruments, they’re not that different from insurance as a general concept. The buyer of the CDS is safe that he will be payed what he’s owed by paying an upfront and then reoccurring fees, on the of other side the seller guarantees the credit worthiness of the fixed income security. Of course, the sellers need to accurately manage their risks, something that didn’t happen in the 2007 and 2008 crisis. Companies like Bear Stearns, Lehman Brothers and AIG failed to manage the risks involved with these swaps and lost an incredible amount of money.

If you’re watching this video there’s a good chance it’s because you watched “The Big Short” movie. The managers in the movie were speculators and they made a bet that the price of Credit Default Swaps were going to appreciate as a result of the defaults that would happen in the mortgage bonds.
Baum and Burry bought CDSs on lower rated mortgage bonds, which had a lower payout given the fact that the underlying mortgage bonds were already starting to crumble. The guys at Brownfield got the highest payout because they bought CDS on higher rated bonds that were thought incredibly unlikely to default.


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