Credit Default Swaps Explained: What They Are and Exactly How They WorkSubmitted by MWF on Wed, 10/26/2011 - 19:35
Here is another article I had written earlier this year on Associated Content. In this article I explain what a CDS is and how it works. I also briefly detail what went wrong and how it happened. I am usually opened ended in my articles and don't always draw definitive conclusions. If you would like to know more of my thoughts I would be happy to share them with you. Here is article below (again I apologize I can only post first two paragraphs).
A Credit Default Swap (CDS) is meant to act as insurance on a bond; however, these derivatives are much more complicated than straightforward insurance policies. First a reminder that insurance is a policy that one buys to protect themselves from a catastrophic event. For example fire insurance is purchased to protect a home owner from the loss of their home in the event of a fire. The way fire insurance works is a homeowner agrees to a contract with a insurance company and agrees to pay the company premiums, meanwhile the insurance company agrees to collect the premiums and in turn will reimburse the policy holder for the value of the home should it catch fire. This is a win-win situation: the homeowner is protected from a catastrophe and the insurance company is able to make money by collecting a large amount of premiums from a large group of customers who are unlikely to experience a catastrophe.
Now back to bonds and credit default swaps. Think about if you were holding a bond that was worth $200,000 from general electric (GE); chances are you would worry about GE going bankrupt, even though it may not be likely for GE to go bankrupt (just like it may not be likely that your house would burn to the ground). The reason you worry is because if they ever did you could lose potentially every cent of your $200,000 investment (just how you would lose all the value in your home if it had burnt to the ground). Therefore you may be interested in purchasing insurance on this bond just in case GE ever went bankrupt or defaulted on the loan. Enter the credit default swap market. The way the credit default swap (CDS) works is you purchase a CDS on the GE bond you hold from either an investment bank, insurance company, or other financial entity. You agree to pay premiums to the institution you purchased the CDS from and they agree to pay you the full $200,000 of the bond should it ever default or become worthless. This would seem like a win-win situation in the case of the fire insurance but CDSs are not that straightforward and are much more complicated than that.
Please continue to link to read entire article http://www.associatedcontent.com/article/7843186/what_is_a_c...