1 00:00:03,210 --> 00:00:06,700 Let us think of our, let's think of a bond, 2 00:00:07,720 --> 00:00:11,750 that promises to pay a constant coupon for ten years. 3 00:00:13,788 --> 00:00:19,445 and now suppose, and now suppose, that we buy a. 4 00:00:19,445 --> 00:00:25,061 [SOUND] 5 00:00:27,720 --> 00:00:32,210 an interest rate swap. in which, in which 6 00:00:32,210 --> 00:00:36,735 we pay, in which one side pays fixed and the other side pays libor. 7 00:00:36,735 --> 00:00:42,516 So,were going to think about this bond as we have this 8 00:00:42,516 --> 00:00:48,680 bond that's paying at, we have the bond here, okay. 9 00:00:52,490 --> 00:00:56,837 And now we're going to do an 10 00:00:56,837 --> 00:00:58,538 [INAUDIBLE] 11 00:00:58,538 --> 00:01:06,916 swap in which we swap Libor, okay, for fixed. 12 00:01:06,916 --> 00:01:07,693 [NOISE]. 13 00:01:07,693 --> 00:01:08,179 Okay. 14 00:01:08,179 --> 00:01:13,551 The point, the point of this, okay, is that what we're, we're getting rid of 15 00:01:13,551 --> 00:01:16,474 the intrist, we're getting rid of the 16 00:01:16,474 --> 00:01:20,335 of the interest rate exposure, the duration exposure. 17 00:01:20,335 --> 00:01:25,695 And what we're, what we're winding up with is essentially a, a long term bond 18 00:01:25,695 --> 00:01:31,660 that play, pays LIBOR plus s percent, you know, some, some credit spread. 19 00:01:31,660 --> 00:01:33,020 This is the credit spread. 20 00:01:33,020 --> 00:01:36,090 But its flexible rate, the LIBOR can change. 21 00:01:36,090 --> 00:01:39,880 LIBOR can change over time and there's, there's 22 00:01:39,880 --> 00:01:43,905 a we've locked in this s percent rate. 23 00:01:43,905 --> 00:01:44,730 [NOISE] 24 00:01:44,730 --> 00:01:51,165 Okay, so it's a flexible rate ten year bond, 25 00:01:51,165 --> 00:01:52,650 [LAUGH] 26 00:01:52,650 --> 00:01:57,105 but with this credit spread 27 00:01:57,105 --> 00:02:00,750 on it. The re, the reason we're, we're, we're 28 00:02:00,750 --> 00:02:06,310 doing the interest rate swap first is so that we can then characterize the 29 00:02:06,310 --> 00:02:11,304 credit default swap. Think of the credit default swap as a 30 00:02:13,052 --> 00:02:18,770 as a premium that you pay every year. 31 00:02:18,770 --> 00:02:21,530 Okay. That the bond is still in existence. 32 00:02:21,530 --> 00:02:23,990 A premium, not of S, but of U. 33 00:02:26,220 --> 00:02:27,370 Okay. 34 00:02:27,370 --> 00:02:31,460 One side pays libor plus u, the other side just pays libor. 35 00:02:32,930 --> 00:02:33,430 Okay? 36 00:02:43,250 --> 00:02:44,390 Oh, no, it's the other way around, isn't it? 37 00:02:47,160 --> 00:02:53,040 no that's right, LIBOR. 38 00:02:55,167 --> 00:03:01,900 what we want to do. 39 00:03:01,900 --> 00:03:06,050 Let me just now show you how the credit, the, this, this works over time. 40 00:03:07,660 --> 00:03:11,512 [NOISE]. 41 00:03:11,512 --> 00:03:16,319 Time one, time two, times 42 00:03:16,319 --> 00:03:21,978 three, time four, time five. 43 00:03:21,978 --> 00:03:25,388 One side of the credit default swap, once, one side of the credit 44 00:03:25,388 --> 00:03:29,210 default swap is going to pay libor times the face value of the bond. 45 00:03:29,210 --> 00:03:29,860 Okay? 46 00:03:29,860 --> 00:03:32,610 The other side is going to pay Libor plus u 47 00:03:32,610 --> 00:03:36,210 times the face value of, of the, of the bond. 48 00:03:36,210 --> 00:03:39,330 Okay. And if I'm buying insurance. 49 00:03:43,290 --> 00:03:44,350 Okay. 50 00:03:44,350 --> 00:03:47,710 Then, I'm the one who's paying Libor plus u. 51 00:03:47,710 --> 00:03:52,890 So I'm, I'm have a negative cash flow in period one. 52 00:03:52,890 --> 00:03:55,250 every time the bond doesn't default, I have to 53 00:03:55,250 --> 00:03:58,160 pay u times the face value of the bond. 54 00:04:01,400 --> 00:04:06,430 Okay, because I'm receiving Libor and I'm paying Libor plus you, so the net is I 55 00:04:06,430 --> 00:04:12,190 have a, a negative cash flow of minus u, that's, that's right, okay. 56 00:04:12,190 --> 00:04:16,860 And the bond doesn't fall, default now. It doesn't default in period two. 57 00:04:16,860 --> 00:04:23,310 And it doesn't default in period three. And it doesn't default in period four. 58 00:04:24,340 --> 00:04:26,563 And then it defaults in 59 00:04:26,563 --> 00:04:29,524 period five. What happens when it defaults? 60 00:04:29,524 --> 00:04:34,598 What happens when it defaults, this is by our thinking about, about a 61 00:04:34,598 --> 00:04:35,200 [UNKNOWN] 62 00:04:35,200 --> 00:04:36,170 here. 63 00:04:36,170 --> 00:04:43,650 Okay, is that I am able to trade the bond for a treasury bond. 64 00:04:44,690 --> 00:04:44,982 Okay? 65 00:04:44,982 --> 00:04:50,090 So that I get the difference between the treasury bond price 66 00:04:50,090 --> 00:04:55,190 and the and the value of the bond. which is 67 00:04:55,190 --> 00:05:00,480 the face value of the bond minus the price of the bond at time five. 68 00:05:00,480 --> 00:05:04,490 So that I get the difference between the face value of, 69 00:05:04,490 --> 00:05:08,115 of I get, I get this up front if it defaults. 70 00:05:08,115 --> 00:05:14,830 [NOISE]. 71 00:05:14,830 --> 00:05:20,480 You can see how this set of exposures, this set of cash flows, follows 72 00:05:20,480 --> 00:05:26,690 from that kind of, of, of, exposure. Here, this is what happens. 73 00:05:26,690 --> 00:05:33,120 This is what happens in the time that that when the coupons are still viable, okay. 74 00:05:33,120 --> 00:05:37,830 What happens when there's default, is that we revert to that picture there, okay. 75 00:05:37,830 --> 00:05:40,140 Where there's treasury bond, 76 00:05:40,140 --> 00:05:45,490 the principal payment here, treasury bond, and corporate bond here. 77 00:05:48,800 --> 00:05:50,428 This is the point I am trying to get at. 78 00:05:50,428 --> 00:05:53,410 This is, because, because bonds are 79 00:05:53,410 --> 00:05:55,670 separated into these coupons and face value. 80 00:05:55,670 --> 00:05:58,760 Okay, there is this annual payment business, and 81 00:05:58,760 --> 00:06:01,248 there is the terminal payment business if it defaults. 82 00:06:01,248 --> 00:06:01,948 Okay. 83 00:06:01,948 --> 00:06:06,030 This is, this is actually how the payments work, 84 00:06:06,030 --> 00:06:10,480 which is not ex, not exactly what I'm showing there. 85 00:06:10,480 --> 00:06:14,080 I mean, if you were, if you were short a, a, a corporate bond, and along 86 00:06:14,080 --> 00:06:17,400 a treasury bond, it wouldn't necessarily all play out this way. 87 00:06:17,400 --> 00:06:19,690 This is the actual way they write the contracts. 88 00:06:23,160 --> 00:06:26,330 Conceptually it's still the, it's still very much, very much the same. 89 00:06:27,350 --> 00:06:28,230 I said that 90 00:06:32,070 --> 00:06:38,980 the credit default swap is, is written as a promise to pay this thing here. 91 00:06:40,650 --> 00:06:45,760 What is this u? Well, you might think that it was s. 92 00:06:48,260 --> 00:06:50,970 You might think that it was s, the credit spread. 93 00:06:50,970 --> 00:06:56,010 Okay, and, you know, so let's just say, I mean, it should be, 94 00:06:56,010 --> 00:07:00,350 if this arbitrage equation sort of works here, it sort of should be. 95 00:07:00,350 --> 00:07:02,510 Okay, so that's a natural thing to think 96 00:07:02,510 --> 00:07:05,110 of, okay, but it's important to appreciate the credit 97 00:07:05,110 --> 00:07:09,100 default swaps are traded in a different market, okay, 98 00:07:09,100 --> 00:07:11,930 and it's always going to be a matter of arbitrage. 99 00:07:11,930 --> 00:07:13,530 Okay. If it's not equal 100 00:07:13,530 --> 00:07:16,780 to u. If s and u are different from each other. 101 00:07:16,780 --> 00:07:17,450 Okay. 102 00:07:17,450 --> 00:07:20,260 Than it certainly looks like there's an arbitrage. 103 00:07:20,260 --> 00:07:20,840 Okay. 104 00:07:20,840 --> 00:07:25,320 That if it's not the same you could either go long bonds and insure them. 105 00:07:25,320 --> 00:07:26,850 Okay. Or the other way around. 106 00:07:26,850 --> 00:07:27,140 Okay. 107 00:07:27,140 --> 00:07:31,330 Short bonds and sell insurance. one or, one or, one or the other. 108 00:07:31,330 --> 00:07:35,650 So it seems like there's an arbitrage argument That 109 00:07:35,650 --> 00:07:37,730 s and u should be, should be the same, 110 00:07:39,390 --> 00:07:40,410 okay. 111 00:07:40,410 --> 00:07:42,960 So let's just, and in fact, that's how modern, 112 00:07:42,960 --> 00:07:44,840 that's how we calculate the price of a CDS. 113 00:07:44,840 --> 00:07:50,700 You calculate the price using these sorts of, these sorts of calculations. 114 00:07:50,700 --> 00:07:53,210 assuming, but this is assuming there's 115 00:07:53,210 --> 00:07:56,460 no liquidity premium anywhere in this picture. 116 00:07:56,460 --> 00:08:01,250 If you enter into the CDS you're, you're entering into a promise 117 00:08:01,250 --> 00:08:05,340 to pay a certain fixed thing for the life of the CDS. 118 00:08:05,340 --> 00:08:10,850 The value of that CDS is going to however fluctuate, right, over, over time. 119 00:08:10,850 --> 00:08:15,250 Just like we saw forward contracts okay, the, that the, are, the value 120 00:08:15,250 --> 00:08:18,450 of that is going to fluctuate over time, just as the bond fluctuates over time. 121 00:08:18,450 --> 00:08:22,020 And It's going val-, it's going to fluctuate inversely. 122 00:08:22,020 --> 00:08:24,310 Okay. So, you might buy this. 123 00:08:24,310 --> 00:08:25,600 This is the point is that you might 124 00:08:25,600 --> 00:08:31,700 buy CDS, not so much as insurance against default. 125 00:08:31,700 --> 00:08:31,930 Okay. 126 00:08:31,930 --> 00:08:34,390 So that the insurance element, but just a 127 00:08:34,390 --> 00:08:37,080 way of getting risk exposure to the underlying bond. 128 00:08:37,080 --> 00:08:40,300 because, remember, I told you, why does the bond price change. 129 00:08:40,300 --> 00:08:42,560 It changes whenever this thing changes. 130 00:08:42,560 --> 00:08:45,280 You know when ever, when ever that, the, the, the, 131 00:08:45,280 --> 00:08:48,240 the discount rate changes the more to discount rate changes. 132 00:08:48,240 --> 00:08:50,800 The same will be true of CDS. Okay. 133 00:08:50,800 --> 00:08:52,560 That the value of CDS is going to 134 00:08:52,560 --> 00:08:55,620 fluctuate, okay, with the value of the bond. 135 00:08:55,620 --> 00:08:57,170 Okay. It's not just 136 00:08:57,170 --> 00:09:00,000 either, either in the money, you know, you are waiting for it to default. 137 00:09:00,000 --> 00:09:02,110 Its not like fire insurance, right. 138 00:09:02,110 --> 00:09:09,380 Fire insurance you buy, and either the house burns down okay, or it doesn't. 139 00:09:09,380 --> 00:09:10,140 Okay? 140 00:09:10,140 --> 00:09:15,280 Either you get paid okay, or your premium goes for nothing. 141 00:09:15,280 --> 00:09:19,350 Not true here because these are, these are liquid assets. 142 00:09:19,350 --> 00:09:22,260 You can make money on them and 143 00:09:22,260 --> 00:09:24,510 then sell them, you know reverse your position, 144 00:09:24,510 --> 00:09:27,560 just as you can in any derivative market. 145 00:09:27,560 --> 00:09:32,160 So CDS are a way to get exposure to credit risk and then you can just trade 146 00:09:32,160 --> 00:09:35,530 them for, for that, it's not, in that sense, 147 00:09:35,530 --> 00:09:38,930 this language of insurance is sort of a misnomer. 148 00:09:38,930 --> 00:09:43,170 I'm using it because people do, and, and also because it helps 149 00:09:43,170 --> 00:09:45,960 you remember which side of the balance sheet we're booking it on. 150 00:09:45,960 --> 00:09:46,460 Okay. 151 00:09:49,530 --> 00:09:54,098 Many people get very agitated, when you talk about 152 00:09:54,098 --> 00:09:59,130 CDS's insurance on both sides of the political spectrum. 153 00:09:59,130 --> 00:10:04,290 Because if it were insurance, it would be regulated as insurance, okay. 154 00:10:04,290 --> 00:10:06,940 And it's not regulated as insurance, okay? 155 00:10:06,940 --> 00:10:10,080 Regulating something as insurance means that you have to hold reserves against 156 00:10:10,080 --> 00:10:11,910 it, then there's, there's all kinds 157 00:10:11,910 --> 00:10:14,960 of appropriateness, standards, and things like this. 158 00:10:14,960 --> 00:10:16,600 it's not regulated as insurance. 159 00:10:16,600 --> 00:10:22,380 Okay so some people don't want it to be called insurance. 160 00:10:22,380 --> 00:10:24,640 other people don't want it to be cob, called insurance, because 161 00:10:24,640 --> 00:10:29,970 in a certain sense what makes insurance work is diversification, right? 162 00:10:29,970 --> 00:10:32,495 That the reason you can write fire insurance 163 00:10:32,495 --> 00:10:33,430 [NOISE]. 164 00:10:33,430 --> 00:10:34,760 Okay, is because there's a lot of 165 00:10:34,760 --> 00:10:38,170 independent risks in these different households, and if 166 00:10:38,170 --> 00:10:42,480 you pool over there, you get kind of actuarial risk, it mostly all washes out. 167 00:10:42,480 --> 00:10:46,260 Okay, it's not clear that credit risk is like that. 168 00:10:46,260 --> 00:10:49,320 Okay, that they're like independent risks of fire. 169 00:10:49,320 --> 00:10:52,620 Okay, there's a lot of systemic risk in, in here. 170 00:10:52,620 --> 00:10:55,610 I mean, corporate bonds all move together. These spreads move together. 171 00:10:56,710 --> 00:10:58,370 it's so, the insurance there's, 172 00:10:58,370 --> 00:11:02,430 that other people get angry when you say insurance, are like, the mathematicians 173 00:11:02,430 --> 00:11:06,560 or economic theorists who say, no, no, it's not insurance really at all. 174 00:11:06,560 --> 00:11:08,000 Okay. 175 00:11:08,000 --> 00:11:11,200 we don't have to get, we can see it's just a swap. 176 00:11:11,200 --> 00:11:11,750 It's a swap. 177 00:11:11,750 --> 00:11:13,110 That's what it is. Okay. 178 00:11:13,110 --> 00:11:16,600 And we'll just remember insurance to keep us, to make sure we 179 00:11:16,600 --> 00:11:18,760 book it on the right hand, the right side of the balance sheet.