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What is a credit default? Credit Default Swaps

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Credit defaults drop, Also known as Credit default exchange, English is CreditDefaultSwaps, Abbreviation CDS It is a financial derivative, which is mainly used to manage credit risks.

It is a contract, which is traded by two participants.One of them pays regular fees as the other party as the other party provides insurance returns when breach of contracts in specific bonds or other debt instruments.

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What is a credit default?

simply put , Credit breach of contract is like a kind of insurance EssenceBuyers purchase credit risk protection for a bond issuer (such as company or government) by paying a time-to -time fee.If the bond issuer defaults (for example, not paying interest or principal on time), the CDS seller promises to pay the buyer to the buyer.

CDS has an important position in the modern financial market.On the one hand, banks, funds, and enterprises can reduce potential losses by purchasing CDS to shedvers credit risk.On the other hand, investors can obtain credit risk information through the CDS market to better evaluate the bond market and corporate credit status.In addition, CDS also provides investors with a way to obtain benefits through arbitrage and speculative activities.

This article aims to introduce the basic concepts, origin and development, trading and pricing, investment strategies, risks and supervision of the basic concept, origin and development, trading and pricing, investment strategies, risks and supervision of the credit breach of credit to help investors in U.S.stocks better understand the CDS market and they are in it and they are inApplication during investment.

What are the main functions of credit default?

There are two main functions of credit default swaps:

  • Risk Management: Financial institutions and investors can reduce the credit risk of holding bonds by purchasing credit breach of contract.This is similar to buying insurance to some extent.If the bond issuer breaks the contract, the credit default exchange will pay related losses, thereby reducing investors’ risk exposure.
  • Speculation: Investors and traders can also speculate on credit risks of specific debt instruments through trading credit breach of contract.For example, if a trader believes that the credit status of a company will deteriorate, they can buy the credit defaults of the company’s bonds.If the company’s credit status does deteriorate, the value of credit default swap may increase, so that traders have profit.

A key feature of the credit default exchange market is that investors who purchase protection do not need to actively hold related bonds.This means that even if investors do not hold relevant debt instruments, they can speculate or hedge risk by purchasing credit defaults.This characteristic makes the credit default exchange market a complex financial trading field.

In short, credit default swaps are a financial derivative, which are mainly used to manage and transfer credit risks.It allows investors to insurance and speculate on the credit risk of specific debt instruments, but also increases the complexity of the market.

Basic concepts and terms of credit defaults

Reference Entity

Reference debtors are the main body of credit risk in the Credit Defense Disposal (CDS) contract.This is usually a company, government or other institutions issuing bonds or loans.

CDS contract buyers pay premiums to sellers in order to hedge the credit risk of reference debtors.Once a credit incident occurs, the seller will provide compensation to the buyer.

Credit Event

Credit events are a specific situation that guides CDS contracts, which usually include breach of contract, reorganization, or bankruptcy of the debtor.

When a credit incident occurs, the CDS seller needs to provide compensation to the buyer in accordance with the terms of the contract.

Cash settlement vs.Physical Settlement)

CDS contracts have two ways to settle after the credit event occurs: Cash delivery and Physical delivery Essence

Cash delivery: The amount of losses caused by the buyer’s payment of credit incidents, that is, the difference between the debt market value of the debtor and the name amount specified in the contract.

Physical delivery: CDS buyers hand over the bonds held to the seller, and the seller pays the name amount specified in the contract.In this way, the buyer can replace the bonds into cash, and the seller needs to bear the credit risk of the debtor.

CDS rate and period

The rate of CDS contract refers to the premium that the buyer needs to pay to the seller.Usually Base point express( 1 Base point is equal to 0.01% To.

The rate reflects the market’s judgment of the credit risk of reference debtor.The higher the risk, the higher the rate.

The period of the CDS contract refers to the time length of insurance protection, usually 1 year, 3 years, 5 years or longer.The CDS contract rates of different periods may be different, which is used to reflect the market’s expectations for future credit risk.

Credit default transactions and pricing

The market structure of CDS trading

The CDS market is mainly composed of large banks, hedge funds, insurance companies and other institutional investors.These market participants are outside the court ( OTC) CDS transactions in the market.

Outside market (OTC) refers to trading outside the centralized exchange.The full English name of OTC is “Over-The-Counter”.In the off-site market, the two parties traded directly through brokers, dealers, or other agencies, rather than trading on a centralized exchange.Overseas markets usually involve financial derivatives, bonds and other financial instruments.This transaction method has higher flexibility, but compared with centralized exchanges, the off-site market usually has lower transparency and high credit risk.

CDS pricing model and method

The pricing of CDS involves the probability, loss rate and risk premium of reference debtors.

Common CDS pricing models include structural models and impairment models.The structural model calculates the probability of breach of contract based on the company’s assets and liabilities, and the impairment model will extract information from historical breach of contract to estimate the probability of breach of contract.

In addition, the market quotation method is a simple pricing method.The market price of other financial instruments (like a credit rating bond with a credit rating) is estimated by referring to the market price of other financial instruments similar to credit risks.

The relationship between credit rating and CDS

Credit rating is the evaluation of the credit risk of the debtor’s credit, and it has a significant impact on the price of CDS.Decreasing credit rating means that the credit risk of debtor’s credit risk is rising, and the premiums of CDS will rise accordingly.

Therefore, investors often use CDS prices as supplementary indicators for credit rating to obtain more comprehensive credit risk information.

In addition, the relationship between credit rating and CDS can also be used to test the accuracy of rating agencies, as well as market expectations for credit risk.

Investment strategy of credit defaults

Hedie risk

CDS can be used to hedge credit risk in the investment portfolio.For example, when investors hold a company bond, they can hedge the potential credit loss by purchasing the company’s CDS.If the company breachs contract, CDS will pay the corresponding losses to investors, thereby offset the loss of bond value.

Similarly, banks and other financial institutions can also use CDS to reduce credit risk in loan portfolios.

Arbitrage

The CDS arbitrage strategy usually involves the purchase and sale of CDS of different debtors or different periods at the same time to use the inconsistency of market pricing.

For example, investors can sell CDS (that is, sell insurance) when they think that CDS prices are too high, and buy other financial instruments (such as bonds) with similar credit risks at the same time to obtain benefits.Conversely, if CDS is considered too low, investors can buy other financial tools with CDS (that is, buy insurance), and sell other financial tools with similar credit risks at the same time.

CDS index and other derivatives

The CDS index is a derivative, and its value is related to the value of a basket of CDS contracts.Investors can get the opening of the entire credit market through the transaction CDS index without having to hold a single CDS contract.

In addition, the CDS index can also be used to build more complex investment strategies, such as credit risk-based factors investment.

In addition to the CDS index, there are other CDS-based derivatives, such as the long-term and CDS options of CDS, which allow investors to buy or sell CDS on a specific date in the future, and to buy or sell CDS.

What are the applications in US stock investment?

Evaluate corporate credit risk

US stock investors can use credit defaults (CDS) to evaluate the company’s credit risk.The price of CDS reflects the market’s view on the risk of reference debtor’s breach of contract.

The rise in CDS’s rates means that the market believes that reference debtors’ credit risk increases, and otherwise it means that credit risk is reduced.Investors can evaluate the corporate credit risk by observing the changes in CDS rates, so as to make more wise investment decisions.

Determine the risk exposure of the investment portfolio

CDS can help investors determine the credit risk exposure in the investment portfolio.Investors can reduce potential losses by hedging the credit risk in the investment portfolio.

For example, investors can buy CDS corresponding to the bonds they hold to hedge the risk of credit events.At the same time, investors can also use CDX and ITRAXX to hedge the credit risk of the entire market or industry by CDX and ITRAXX.

The impact and prediction of credit default swaps on the US stock market

The changes in credit default market may have an impact on the US stock market.For example, rising risk premium in the CDS market may indicate the tension of the credit market, which has a negative impact on the stock market.In addition, changes in the CDS market can also provide investors with forecasts on future trends of enterprises and industries.In some cases, changes in the CDS market may send signals before major changes in the stock market.

In general, there are many applications in US stock investment, including assessing corporate credit risks, determining the risk exposure of investment portfolios, and predicting the US stock market.Investors should pay attention to changes in the CDS market and make full use of CDS tools to optimize investment strategies.

How did credit default swaps develop?

The origin of the Credit Defense Disposal (CDS) dates back to the 1990s.In 1994, JP Morgan Bank developed CDS products for the first time to help his credit risk in hedge loan portfolio.With the development of the global financial market, the CDS market has gradually grown, which has become an important risk management tool and investment channel.

From 2000 to 2007, the scale of the CDS market increased rapidly from about 180 billion US dollars to $ 62 trillion.

When the financial crisis broke out in 2008, the CDS market was huge, which had an important impact on the stability of the financial system.Many financial institutions in the CDS market have led to the rapid spread of credit risk and exacerbated the deterioration of the financial crisis.In particular, the bankruptcy incident of the Lehman brothers of the US Investment Bank triggered a huge claim in the CDS market and exposed the risk of credit defaults.

The opaque and risk concentration issues in the CDS market have aroused widespread attention and have become a major cause of the financial crisis.

After the financial crisis, global regulators carried out a series of reform measures for the CDS market to increase market transparency, reduce concentration of risk, and strengthen risk management.

These reform measures include: Introduce the central opponent (CCP) for CDS transactions, improve transaction reports and disclosure requirements, and restrict certain types of CDS transactions, such as naked selling (that is, CDS sellers without relevant bonds), and as well as, and as well as, and as well as, and as well as, as well as, and as well as the seller of related bonds), and and as well as, as well as the seller of the relevant bonds), and as well as the seller of the CDS)Strengthen the supervision and capital requirements for CDS transactions in financial institutions.

These reforms make the CDS market more standardized and stable to a certain extent, but at the same time, it may also lead to the reduction of market participants and the weakening of trading activities.

What are the investment risks of credit default?

Opponent’s credit risk

The risk of opponents’ credit risk refers to the risk that one party may not be able to fulfill contract obligations in CDS transactions.

For example, when a credit event occurs, the CDS seller may not be able to pay the amount of compensation required for the purchaser.The opponent’s credit risk may lead to the systemic risk of the CDS market, because the CDS exposure between financial institutions may be interrelated, thereby forming a risk infection chain.

Liquidity risk

Liquidity risk means that investors may be difficult to buy or sell CDS contracts in a short time without affecting market prices.

Because the CDS market is mainly an overseas trading market, the volume and transparency may be low, and investors may face greater liquidity risks during the transaction process.

Manipulate market risk

Manipulating market risks means that market participants may use CDS prices to manipulate the company’s credit rating and bond prices.

For example, by short CDS, investors can create the illusion of worsening the credit status of a company, which affects corporate bond prices and credit rating.Manipulating market risks may lead to the deviation between CDS price and actual credit risk, thereby distorting the market pricing mechanism.

Regulatory agency and policies

In order to reduce the risk of the CDS market, regulators have adopted a series of policy measures.

For example, after the financial crisis, the Dodd-Frank Act requires CDS transactions to liquidate through the central opponent (CCP) to reduce the risk of opponent’s credit.

In addition, regulators also require market participants to increase the transparency of CDS exposure to reduce the risk of manipulating market.However, there may be differences in regulatory policies between countries, which may bring potential uncertainty and risks to the CDS market.

At the end

After the adjustment and regulatory reform of the financial crisis in 2008, the credit default market has gradually resumed stability.As an important financial derivative, CDS still plays an important role in the global financial market.With market participants’ understanding of CDS and the optimization of regulatory environment, the CDS market will continue to develop and improve.

Investors can use CDS to evaluate corporate credit risks in the U.S.stock market, determine the risk exposure of investment portfolios, and use CDS for hedging and arbitrage strategies.However, investors need to understand the risks of the CDS market, including the risk of credit, liquidity risks, and market risks of the opponent, and treat them with caution during investment.At the same time, follow the changes in regulatory policies in order to adapt to changes in the market environment.