Credit-default swaps are derivatives, meaning they're financial contracts that don't contain any actual assets. Their value is based on the worth of underlying loans and bonds. Swaps are similar to insurance policies -- with two key differences.."
Unlike with traditional insurance, no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. In addition, swap buyers don't need to actually own the asset they want to protect.
It's as if many investors could buy insurance on the same multimillion-dollar home they didn't own and then collect on its full value if the house burned down
Monday, May 26, 2008
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Of course, if we could buy insurance on homes we did not own the cost of insurance on homes would go down.
The value of credit swaps is that they allow an asset investor to segregate the risk they want to take--interest rate versus credit risk. Nothing inherently wrong with this. People who took the credit risk just did not do their homework.
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