So I thought I should post something relevant to my internship before I finish up this week…the two types of instruments which are dealt with on a most regular basis, are Interest-rate swaps and credit-default swaps:
An interest rate swap is a contractual agreement to exchange a stream of periodic payments with a counterparty. The traditional interest rate swap agreement is an exchange of fixed interest payments for floating rate payments:
(Click to enlarge)
A Credit default swap (CDS) is a swap designed to transfer the credit exposure of the reference obligation between parties.
It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity
§ A pension fund owns USD 10 million worth of a 5 year bond issued by Risky Corporation;
§ In order to manage their risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of 10 million dollars which trades at 200 basis points;
§ In return for this credit protection, the pension fund pays 2% of 10 million (200,000 euro) in quarterly installments of 50,000 euro to Derivative Bank;
§ If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its 10 millions loan back after 5 years from the Risky Corporation;
§ Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario is eliminated;
§ If Risky Corporation defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the pension fund is refunded for its loss of USD 10 million
Economic Equities 