November 13, 2008

The Credit-Default Swap: What is this thing, anyway?

by Christian Bowne

U.S. Securities & Exchange Commission Chairman Christopher Cox recently acknowledged that the $33 trillion market in credit-default swaps is regulated by no one. Billionaire Warren Buffet, in a 2003 prediction worthy in its prescience of Nostradamus, warned, "The rapidly growing trade in derivatives poses a mega-catastrophic risk for the economy, derivatives are financial weapons of mass destruction that could harm not only their buyers and sellers, but the whole economic system." Finally, President George W. Bush calls for "extraordinary measures under extraordinary circumstances" in deference to his ordinary gravitation toward unfettered capitalism.

A credit-default swap is a contract in which a buyer makes a series of payments to a seller to receive a right to payoff if the credit instrument defaults or another specified credit event such as restructuring or bankruptcy occurs. A credit-default swap is a credit "derivative," gaining its value from the underlying credit risk of a given financial instrument. These underlying financial instruments include commodities like oil, loans, bonds and indeed residential subprime mortgages, to name only a few.

The so called "swap" is a derivative in which two parties agree to exchange the risk of one stream of cash flow against another.-------------------------------------> More

No comments: