Let us think of our, let's think of a
bond,
that promises to pay a constant coupon for
ten years.
and now suppose, and now suppose, that we
buy a.
[SOUND]
an interest rate swap.
in which, in which
we pay, in which one side pays fixed and
the other side pays libor.
So,were going to think about this bond as
we have this
bond that's paying at, we have the bond
here, okay.
And now we're going to do an
[INAUDIBLE]
swap in which we swap Libor, okay, for
fixed.
[NOISE].
Okay.
The point, the point of this, okay, is
that what we're, we're getting rid of
the intrist, we're getting rid of the
of the interest rate exposure, the
duration exposure.
And what we're, what we're winding up with
is essentially a, a long term bond
that play, pays LIBOR plus s percent, you
know, some, some credit spread.
This is the credit spread.
But its flexible rate, the LIBOR can
change.
LIBOR can change over time and there's,
there's
a we've locked in this s percent rate.
[NOISE]
Okay, so it's a flexible rate ten year
bond,
[LAUGH]
but with this credit spread
on it.
The re, the reason we're, we're, we're
doing the interest rate swap first is so
that we can then characterize the
credit default swap.
Think of the credit default swap as a
as a premium that you pay every year.
Okay.
That the bond is still in existence.
A premium, not of S, but of U.
Okay.
One side pays libor plus u, the other side
just pays libor.
Okay?
Oh, no, it's the other way around, isn't
it?
no that's right, LIBOR.
what we want to do.
Let me just now show you how the credit,
the, this, this works over time.
[NOISE].
Time one, time two, times
three, time four, time five.
One side of the credit default swap, once,
one side of the credit
default swap is going to pay libor times
the face value of the bond.
Okay?
The other side is going to pay Libor plus
u
times the face value of, of the, of the
bond.
Okay.
And if I'm buying insurance.
Okay.
Then, I'm the one who's paying Libor plus
u.
So I'm, I'm have a negative cash flow in
period one.
every time the bond doesn't default, I
have to
pay u times the face value of the bond.
Okay, because I'm receiving Libor and I'm
paying Libor plus you, so the net is I
have a, a negative cash flow of minus u,
that's, that's right, okay.
And the bond doesn't fall, default now.
It doesn't default in period two.
And it doesn't default in period three.
And it doesn't default in period four.
And then it defaults in
period five.
What happens when it defaults?
What happens when it defaults, this is by
our thinking about, about a
[UNKNOWN]
here.
Okay, is that I am able to trade the bond
for a treasury bond.
Okay?
So that I get the difference between the
treasury bond price
and the and the value of the bond.
which is
the face value of the bond minus the price
of the bond at time five.
So that I get the difference between the
face value of,
of I get, I get this up front if it
defaults.
[NOISE].
You can see how this set of exposures,
this set of cash flows, follows
from that kind of, of, of, exposure.
Here, this is what happens.
This is what happens in the time that that
when the coupons are still viable, okay.
What happens when there's default, is that
we revert to that picture there, okay.
Where there's treasury bond,
the principal payment here, treasury bond,
and corporate bond here.
This is the point I am trying to get at.
This is, because, because bonds are
separated into these coupons and face
value.
Okay, there is this annual payment
business, and
there is the terminal payment business if
it defaults.
Okay.
This is, this is actually how the payments
work,
which is not ex, not exactly what I'm
showing there.
I mean, if you were, if you were short a,
a, a corporate bond, and along
a treasury bond, it wouldn't necessarily
all play out this way.
This is the actual way they write the
contracts.
Conceptually it's still the, it's still
very much, very much the same.
I said that
the credit default swap is, is written as
a promise to pay this thing here.
What is this u?
Well, you might think that it was s.
You might think that it was s, the credit
spread.
Okay, and, you know, so let's just say, I
mean, it should be,
if this arbitrage equation sort of works
here, it sort of should be.
Okay, so that's a natural thing to think
of, okay, but it's important to appreciate
the credit
default swaps are traded in a different
market, okay,
and it's always going to be a matter of
arbitrage.
Okay.
If it's not equal
to u.
If s and u are different from each other.
Okay.
Than it certainly looks like there's an
arbitrage.
Okay.
That if it's not the same you could either
go long bonds and insure them.
Okay.
Or the other way around.
Okay.
Short bonds and sell insurance.
one or, one or, one or the other.
So it seems like there's an arbitrage
argument That
s and u should be, should be the same,
okay.
So let's just, and in fact, that's how
modern,
that's how we calculate the price of a
CDS.
You calculate the price using these sorts
of, these sorts of calculations.
assuming, but this is assuming there's
no liquidity premium anywhere in this
picture.
If you enter into the CDS you're, you're
entering into a promise
to pay a certain fixed thing for the life
of the CDS.
The value of that CDS is going to however
fluctuate, right, over, over time.
Just like we saw forward contracts okay,
the, that the, are, the value
of that is going to fluctuate over time,
just as the bond fluctuates over time.
And It's going val-, it's going to
fluctuate inversely.
Okay.
So, you might buy this.
This is the point is that you might
buy CDS, not so much as insurance against
default.
Okay.
So that the insurance element, but just a
way of getting risk exposure to the
underlying bond.
because, remember, I told you, why does
the bond price change.
It changes whenever this thing changes.
You know when ever, when ever that, the,
the, the,
the discount rate changes the more to
discount rate changes.
The same will be true of CDS.
Okay.
That the value of CDS is going to
fluctuate, okay, with the value of the
bond.
Okay.
It's not just
either, either in the money, you know, you
are waiting for it to default.
Its not like fire insurance, right.
Fire insurance you buy, and either the
house burns down okay, or it doesn't.
Okay?
Either you get paid okay, or your premium
goes for nothing.
Not true here because these are, these are
liquid assets.
You can make money on them and
then sell them, you know reverse your
position,
just as you can in any derivative market.
So CDS are a way to get exposure to credit
risk and then you can just trade
them for, for that, it's not, in that
sense,
this language of insurance is sort of a
misnomer.
I'm using it because people do, and, and
also because it helps
you remember which side of the balance
sheet we're booking it on.
Okay.
Many people get very agitated, when you
talk about
CDS's insurance on both sides of the
political spectrum.
Because if it were insurance, it would be
regulated as insurance, okay.
And it's not regulated as insurance, okay?
Regulating something as insurance means
that you have to hold reserves against
it, then there's, there's all kinds
of appropriateness, standards, and things
like this.
it's not regulated as insurance.
Okay so some people don't want it to be
called insurance.
other people don't want it to be cob,
called insurance, because
in a certain sense what makes insurance
work is diversification, right?
That the reason you can write fire
insurance
[NOISE].
Okay, is because there's a lot of
independent risks in these different
households, and if
you pool over there, you get kind of
actuarial risk, it mostly all washes out.
Okay, it's not clear that credit risk is
like that.
Okay, that they're like independent risks
of fire.
Okay, there's a lot of systemic risk in,
in here.
I mean, corporate bonds all move together.
These spreads move together.
it's so, the insurance there's,
that other people get angry when you say
insurance, are like, the mathematicians
or economic theorists who say, no, no,
it's not insurance really at all.
Okay.
we don't have to get, we can see it's just
a swap.
It's a swap.
That's what it is.
Okay.
And we'll just remember insurance to keep
us, to make sure we
book it on the right hand, the right side
of the balance sheet.