Can anyone explain me what is a Credit Default Swap? And what are the merits and demerits of it?
In: Other
They act like insurance on a loan. You pay a small premium, and if loan defaults you get paid. If you are a lender, it’s a way to reduce risk.
However, they became risky in the overall financial markets because one doesn’t need to own the underlying debt to buy a credit default swap on it. It’s be like you taking out a policy where you get paid out insurance claim, too, when your neighbor’s house burns down.
During the financial crisis of 2008, the premiums for credit default swaps on mortgage backed securities were crazy low due to supposed low risk. And because the swaps were worth something like 5x the underlying investments, when they began to default the payouts on the defaults were massive, bankrupting the issuing investments banks and insurance companies.
Latest Answers