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AIG's house of cards

Francesca R said:
I assume you're not actually trading in CDSs, but to correct a possible misapprehension, they are not "binary payoffs" that either cough up loadsa lolly or remain worthless. Like swap contracts generally, the standard is to exchange (swap, that is) a floating short term interest rate for the expected return on something else, such as a Citi bond. If market expectations on the return from Citi's bonds goes bad (because of an expected default probability and a less than full recovery rate) then the CDS makes money and could be sold in the market at a profit at that point.
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Wait. That's different, isn't it? A credit default swap doesn't have anything to do with exchanging interest, does it?
 
Francesca R said:
A short term floating interest rate (LIBOR), plus a (variable) spread is almost always one side of the transaction yes.
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Hmm.. I think you're talking about an interest rate swap, where one party trades interest for cash flow.

I don't know much about that. I was talking about a credit default swap, and specifically a swap with a reference entity that is unaffiliated with either party, ie - betting on failure of a reference entity. I don't see what the spread of the bond has to do with it.

Is there something I don't understand?
 
Yes there is. Namely that one side of a CDS is to pay floating interest rates (plus a spread). They're not free (or we'd all grab a bunch of them wouldn't we? :)).
 
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Francesca R said:
I assume you're not actually trading in CDSs, but to correct a possible misapprehension, they are not "binary payoffs" that either cough up loadsa lolly or remain worthless. Like swap contracts generally, the standard is to exchange (swap, that is) a floating short term interest rate for the expected return on something else, such as a Citi bond. If market expectations on the return from Citi's bonds goes bad (because of an expected default probability and a less than full recovery rate) then the CDS makes money and could be sold in the market at a profit at that point.
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Okay, but for the record, what you have described above is an interest rate swap for cash flow.

Not a credit default swap. Correct?

The reason I'm obsessing over this is because I thought I understood a CDS, and from your description, it is either that you're talking about an interest rate swap, or I don't get it at all.

If it's totally above my head, or requires a learning curve that I have to go to college to understand or something, that's fine. Let me know, so I can stop obsessing over it.
 
No that description was a CDS on a Citi bond. You are buying protection against the bond defaulting (failing to pay a coupon etc). To do that you need to buy the market's prevailing expected probability of this bond defaulting. (And default isn't "You get nothing, suckerrrr!", it is simply not getting the face value of originally promised cash flows).

Maybe you can google or wiki about swaps. There are swaps traded on many different things (bond yields, credit defaults, equity indexes, property indexes, commodity indexes, inflation rates). In every case there are cash flows paid and received.
 
Francesca R said:
No that description was a CDS on a Citi bond. You are buying protection against the bond defaulting (failing to pay a coupon etc). To do that you need to buy the market's prevailing expected probability of this bond defaulting. (And default isn't "You get nothing, suckerrrr!", it is simply not getting the face value of originally promised cash flows).

Maybe you can google or wiki about swaps. There are swaps traded on many different things (bond yields, credit defaults, equity indexes, property indexes, commodity indexes, inflation rates). In every case there are cash flows paid and received.
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Okay, one more thing, then I'll shut up about it.

Tell me what I'm missing in this scenario.

I buy a 10 billion dollar CDS from AIG to speculate on a Citibank Corporate Bond, that I think, for whatever reason, they will default on, or miss a payment or whatever. So, (if we compare it to insurance) the premium payments that I have to make to AIG are 500,000 dollars per year, or if it's monthly, then like 40something thousand a month. Right? So if Citibank defaults on this bond, I would get the $10 million (minus recovery).

Are you saying that the "premium" in my example is the rate determined by something like LIBOR and other factors?
 
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There are swaps traded on many different things (bond yields, credit defaults, equity indexes, property indexes, commodity indexes, inflation rates). In every case there are cash flows paid and received.
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How much of this is driving US currencies levels against others??
 
Francesca R said:
Can I leave you with this? It's too late in the day for me to go over it, and the link does a reasonable job actually

http://en.wikipedia.org/wiki/Credit_default_swap#Pricing_and_valuation
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Wow. Probability Model: still a little bit :confused:

Basic concept: I got it.

This I found interesting. It is true that entering a CDS transaction gives you counterparty risk, but bear in mind that it is also possible to hedge this risk by buying CDS protection on your counterparty!

And then I'm assuming you could purchase a CDS on the counter-counterparty as well...

That's just strange. If you have doubts about the company's creditworthiness with whom you are purchasing a CDS from, why are you buying a CDS through them in the first place? That's just mind-boggling.
 
Counterparty risk exists yes. It is minimised but not eliminated by collateral arrangements (see links in post 18) though.

As I said, Lehman Brothers was a counterparty for a lot of CDSs when it failed over the weekend of 13-14 September. So if you had bought protection on--say--AIG with Lehmans as the other side of the trade, you would have been sitting on an unrealised profit at that point (because speculation was very high that AIG would default at that point so the spread of an AIG CDS had widened so you could close out your contract in the money). Up until the Friday before (12th) Lehman would have had to post collateral in your favour under the (likely) ISDA agreement that you and Lehman would have executed and that collateral (which would have to be cash or treasury bills, not toxic waste) would slightly exceed the amount of your unrealised gain/their unrealised loss.

Once Lehman went under, it would have been rather messy, but that gain would have been yours. Anything that happened to the contract in between 12th and the first point at which you got to do anything about it would probably be lost.

As I said, this actually happened and it worked itself out OK, despite the CDS market being over-the-counter and not co-ordinated by any central exchange or clearing house. (There have been suggestions to create one since). I and several of my colleagues around the world was at work on Sunday 14th for this reason. Although the bankruptcy announcement wasn't made until late at night, trading was allowed to occur for a part of the day: http://www.isda.org/press/press091408lehman.html.
 
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Hey most people think they are COTU - you actually were :boggled:

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Francesca wrote
Quote:
There are swaps traded on many different things (bond yields, credit defaults, equity indexes, property indexes, commodity indexes, inflation rates). In every case there are cash flows paid and received.
Click to expand...

How much of this is driving US currencies levels against others??

any chance of an insight on this???? Is the US going to continue the levitation?

TIA
 
Just to add to the story, from: http://www.cnbc.com/id/29530187/for/cnbc/

Citigroup CDS hit record as financials weaken
| 05 Mar 2009 | 11:32 AM ET

NEW YORK, March 5 (Reuters) - The cost to insure the debt of Citigroup hit a record high on Thursday as concerns about bad loans at banks and financial firms continued to weigh on the credit market. Citigroup's credit default swaps spreads widened to around 551 basis points, or $551,000 per year for five years to insure $10 million in debt, from around 491 basis points on Wednesday, according to Markit Intraday.
 
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