October 2nd, 2008A primer on credit default swaps and counterparty risk
For those looking to better understand the credit default swap market and all the intertwined counterparty risk, seekingalpha has a great summary here. I had intended to write a similar description, but no sense in re-inventing the wheel.
With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up…However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas…the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system.
For a more detailed view of credit swaps, counterparties, interest rate swaps and options, currency options, risk management with options, and more, then the following is a must read:
Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options (The Wiley Finance Series) by Andrew M. Chisholm