Swaps and Such

After talking a couple of people who had read my previous post I believe I need to explain a couple more things as relates to credit default swaps.

To maybe explain a little bit better, a general swap is when I make a contract with someone else to give them say 100 dollars a month for two years. If in those two years an asset that I'm holding loses value then I can call in the swap, depending on the particular features of the contract, so that you pay me the original value of the asset and I give you the asset. So in a credit default swap the underlying asset is a bond and the loss of value is defined as a default on the bond. There are a couple of other features of credit default swaps such as automatic reworking of the terms of the swap if the bond is downgraded or the bond yield rises, which means that demand for the bond is down possibly due to fears that it will default.

The largest problem as I explained in the last post was that you don't have to own the underlying asset. Multiple swaps can be placed in relation to one bond, inflating the downside risk of a particular default. Probably the best thing to do for swaps is to make it so that if you create one then you have to own the underlying asset. Then only one swap can exist per asset. Other basic regulations are that there has to be an exchange like a stock exchange where these swaps are sold. If all of the deals are whats called over the counter then knowing the size of the market and the valuation of risk in the economy in real time is much more difficult. One thing that is freezing the banks is the lack of information on what everyone owns and what the actual risk is.

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