uppose a high graded institution (let us call it 'AA Bank') is approached by
a low graded company (we call it 'Business') for a loan. Business is prepared
to pay significant interest on the balance. However, there is a noticeable
risk of default. If AA Bank issues a loan then both regulatory oversight and
the public credit companies (S&P, Moody) would require that AA Bank keep
significant reserve capital against such transaction. This reserve capital
requirement would significantly reduce the profit and still leave AA Bank
exposed to the risk of loss.
Instead, Business may approach a low grade lending institution, we call it "BB
Bank". BB Bank do not have the same problem with oversight. However, it
suffers from high borrowing costs itself. Hence, if it lends to Business, then
its profit would also be low against the same risk of loss.
The situation resolves with introduction of Credit Default Swap. AA Bank lends
to Business and purchases insurance against default by Business written by BB
Bank. This way AA Bank is only exposed to the simultaneous default by the BB
Bank and Business and does not need to keep the reserve capital. AA Bank keeps
the difference between the ingoing and outgoing coupon payments. BB Bank
receives coupon in exchange for its obligations and do not need to procure any
capital.
The described above situation is an illustration of a general tendency.
Financial instutions create wealth by ignoring some risk that is perceived as
almost non-existent. Initially such perception (that Business and BB Bank
would not default simultaneously) is correct. However, as more people join the
same activity, the total amount of notional on the market becomes so great
that the presence of these contracts significantly increases the probability
of the event that was initially perceived as nearly impossible. When the signs
of the trouble arrive, AA Bank might move to close the position or purchase
additional insurance and discover that the necessary liquidity is no longer
present.
The reference for the math of the following sections is
[AndersenOnLine]
.
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