Derivatives VIII --- CDS and CDO

Before getting into these two products, we need to understand what credit does. Credit is like glue that holds banks together. If you take credit risk, i.e., you lend money to others but they don’t pay you back, you are in trouble. The risk is removed until they pay you back. This can be a very long period of time. Credit agencies play the words of “A” (the company will pay you back) and “B” (they may pay you back).

Because of the credit risk, there must be a way to diversify the risk. Here comes the first credit derivatives: credit default swap (CDS). The idea of CDS is like this: assume that a bank has made a loan to a client. The banks want to sell the risk on the loan because it has too much exposure to the loan. So the bank finds someone who wants to take the risk. Someone likes the client company and doesn’t think the client would default, or he simply is unaware of the risk. So the bank and the investor enter into a CDS. The bank pays the investor a fee. In return, the investor agrees to indemnify the bank against losses if the company defaults. CDS ensembles a guarantee against bankruptcy.