Credit Default Swaps

A Credit Default Swap (CDS) is a financial contract in which one party purchases the right to receive the notional amount of an underlying credit backed security in exchange for a series of payments. The underlying assets are typically compromised of fixed income securities backed by credit vehicles such as bonds and residential mortgaged backed securities. The purchaser of the CDS, the party who pays the periodic premiums, takes the long position while the issuer of the CDS, the party who receives the periodic payments, takes the short position. However in terms of the underlying assets the purchaser is short and the issuer is long. While CDSs are often compared to insurance policies and put options there are differences. Unlike insurance, the purchaser of a CDS need not own the underlying asset. This attribute of CDSs results in two interesting but also volatile conditions. First, since the purchaser need not own the underlying asset there is no maximum to the amount of CDSs in existence. Any number of parties could, in theory, purchase CDSs on IBM bonds. Second, the purchaser of the CDS need not be a hedger. CDSs, due to their flexibility, are an excellent tool for investors to speculate on the ability of companies, governments and individuals to repay debt.

The following is a fairly interesting article published on June 10, 2010, regarding BP PLC's Bonds and CDS pricing and the impact that the Gulf oil spill crisis' current and predicted future cleanup costs are having.

http://www.bloomberg.com/apps/news?pid=20601010&sid=aO0ksCTaZJUI

The market is pricing in a more and more liklihood of a BP default. Currently at record highs, this article states that BP currently is being priced at a 40% chance of bancruptcy in the next 5 years.

http://www.cnbc.com/id/37734092