Introduction to Credit Default Swaps Case Solution
Credit Default Swaps (CDS)is a financial swap agreement, which allows the protection of investors-against the credit events, which include downgrades or defaults by the basket of obligatory or the single-name obligatory. The credit default swap is estimated to be at 32.6 trillion dollars by the Band of International Settlements in December 2009, and it represents one of the fastest and largest growing financial product markets internationally. The case sets out to investigate and assess the credit default swap, the pricing basics as well as the role in the subprime crises of year 2008(Muhammad Fuad Farooqi, Introduction to Credit Default Swaps, 2010).
Factors have contributed to the major usage of the CDS market
As the market was unregulated; the usage of swaps had increased to ensure the financial products. The rapid growth of the credit default swap’s market is followed by higher demand for the structured solutions in the credit risk management field, which in turn led to the introduction of the credit default swap.
As the onset of the global recession as well as credit crises, all the credit markets were being marked by volatility & massive spread widening. The credit instruments, such as: credit default swaps tend to garner attention to the credit risk. Predominantly, the usage of credit default swap is based on heading afterwards for the purpose of trading. As the market matured with the passage of time, banks, hedge funds and asset managers increasingly used credit default swap with core consideration over providing impetus to the market growth as well as for taking position in the default risk.
In addition to this, the exponential-growth in the use of the credit default swap was experienced by the markets to trade and hedge the credit risk.The derivatives tend to enjoy the widespread use in part, due to the fact that it provides a larger risk exposure with minimal-disclosure and minimal up-front capita required. The credit default swap gained popularity among different financial sector’s participants. Thus, the factors which have contributed to an increased use of the credit default swap, includes an increased volatility in the market as a whole, unwinding carry trade in the global markets, increased risk exposure in the financial market and the multinational firms’ operations and trade in multiple currencies.
Strategies and its advantages
If the company owns 200 million dollar portfolio of the account receivable on the diverse base of the industrial customers; it must hedge strategies in order to hedge itself against the risk of default from the customers. The recommended hedging strategies against the account receivable default risk, are as follows:
Credit Default Swap Agreement
To hedge itself from the risk of default by the customers; the company could use the credit default swap agreement as it provides a strong foundation to swap or offset the risk of default, thus protecting itself from the risk of losing cash (money). One of the greater advantages of using the credit default swap agreement, is that the firms that trade tend to collect account receivable payments from the customers or buyer more quickly. Under the agreement of the credit default swap; the seller or the company tend to negotiate the fee (either continuous or up-front) for the purpose of compensating the buyer if they are not eligible to pay or default in the near future. Furthermore, the steady payments’streams are ensured with a little downside risk. The recommended derivative instrument are of high importance, as they help the company in achieving its objectives or goals more efficiently.(Muhammad Fuad Farooqi, 2010).
Forward or future contracts
The company could use the forward or future contracts against the risk of default on account receivables as a mean of fixing the future rate, thus reducing the downside risk exposure, providing flexibility regarding the amount to be covered and eliminating the uncertainty related to the changes in the exchange rate as well as preventing the potentials losses from adverse movements in the market………………..
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