What is a sovereign credit default swap?
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What is a sovereign credit default swap?
Credit default swaps are credit protection contracts whereby one party agrees, in exchange for a periodic premium, to make a contingent payment in the case of a defined credit event.
How are credit default swaps calculated?
When a bond defaults, the buyer of the CDS is entitled to the notional principal minus the recovery rate of the bond. The recovery rate of the bond is considered its value immediately after default. So if the recovery rate on $1,000,000 worth of bonds is 75\%, then the CDS payoff = $1,000,000 × (1 – . 75) = $250,000.
What happens when a bond defaults on a credit swap?
If the reference bond defaults, the protection seller pays par value of the bond to the buyer, and the buyer transfers ownership of the bond to the seller. A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event.
How much was covered by credit default swaps?
Of that, $400 billion was “covered” by credit default swaps. 2 Some of the companies that sold the swaps were American International Group (AIG), Pacific Investment Management Company, and the Citadel hedge fund. These companies didn’t expect all the debt to come due at once.
What are credit swaps and how do they work?
Like an insurance policy, the buyer makes periodic payments to the seller. Most of these swaps protect against the default of high-risk municipal bonds, sovereign debt, and corporate debt. Investors also use them to protect against the credit risk of mortgage-backed securities , junk bonds , and collateralized debt obligations .
Why did JP Morgan Chase introduce credit default swaps?
JPMorgan Chase first introduced credit default swaps in 1994. It wanted to insure itself against the risk of default on the loans it held on its books, but these products ultimately led to some of its greatest losses. 7 The Greek Debt Crisis and CDS Swaps’ false sense of security also contributed to the Greek debt crisis.