CDS explained part 1. What are credit default swaps??

Since the collapse of Lehmann Brothers on the 15th of September 2008, we have been hearing increasingly more about credit default swaps. But what exaclty are these?

A credit default swap is conceptually a sort of insurance. The way a CDS works is really simple. First of all, whoever buys a CDS is buying an insurance on something. The buyer of insurance then pays a premium (interest) to the seller of protection periodically. In the case a credit event should occur, which is a pre-specified event that triggers the default of the contract, the seller of insurance has to deliver the notional amount specified on the contract to the buyer of protection in exchange for the underlying credit asset. This is the ONLY case in which the CDS seller pays the buyer. If a credit event does not occur, the contract expires at maturity.

The underlying assets on a CDS contract may vary. They are typically governments and corporations bonds, but they might include any financial instrument or index for which someone might want to buy protection, and for which someone might to sell it.

In the case that solvency of a sovereign or of an institution is being insured, the credit event is typically triggered by bankrupcy, but credit events might refer to a variety of other events, depending on the contract. Examples of other sources of credit event can be the downgrading of a credit rating, a fall in index level or share price, or even an natural disaster, such as a tsunami or an earthquake.

The only difference with traditional insurance is that the buyer of protection does not need to actually own the underlying asset.

Thus CDS are very flexible instruments that can be useful to the purpose of risk management. But how are they priced? As your intuition might suggest, they are traded openly and they have fluctuating prices. In the case that the underlying asset is a sovereing bond, the main fundamental factors used to assess the credit quality of the sovereing issuer are: the budget deficit, the debt-to-GDP ratio and the current account. (Criado, S. et al. 2010)

For further clarification of what these financial instruments are, follow this link:

http://www.youtube.com/watch?v=jHVnEBw93EA