Credit Default Swap Ratio
Having an understanding of credit default swaps could be difficult. We can say credit default swaps are comparable to insurance. However, these are not under the control of any government agency such as Securities and Exchange Commission. Many consider credit default swaps to be the basic reason for the crash of housing market during 2008-2009. A credit default swap is most likely when the level of exposure to fiscal risk is more than the funds available for paying creditors.
Credit Default Swaps
As per their their usual ways of conducting businesses, companies get large chunks of comparable investments like real estate mortgages. With the intention of reducing their risk in case of sizeable number of mortgagees failing to make payments, these companies buy credit default swaps, thus transferring some component of risk to third party. Generally, such bodies are groups of big institutional investors like investment banks, hedge funds, wealthy individuals or families and rich corporations with surplus cash. Mortgage companies utilize credit default swaps to transfer their risks to such institutional investors by paying them a premium. In case of the real default exceeding the predefined limits, the institutional investors have to make payment to the mortgage company as per the agreement made by them.
Credit Default Swap Leverage Ratio
This is the ratio of the full amount of the financial liability exposure divided by the full amount of invested capital. Financial liabilities comprise of the grouping of worth of stocks, financial instruments like bonds, rates of interest and the volume of credit offered to borrowers. The full amount of invested capital is the market worth of stocks and bonds possessed by the borrower. For instance, when a borrower has stocks worth $2 million, a brokerage company could lend $6 million to the borrower, utilizing stocks worth $2 million as collateral. That way, the borrower gets $8 million for executing securities trades, thus increasing the returns that the borrower may earn as also losses that he can maintain.
Associated risks of credit default swaps
There are many risks connected with credit default swaps. During the financial disaster of 2007-2009, it was realized that many issuers of credit default swaps did not keep adequate reserves with them for making payments as per the conditions of the contracts at the time the mortgages possessed by real estate banks started collapsing. Issuers of credit default swaps are exposed to the risk of increased rates of interest, liquidity of bonds and stocks, natural disasters and revised policies of the government. Other risks may also include option spreads, duration of bonds and beta.
Another Credit default swap ratio
Credit swap ratios are calculated in different ways, as per the kind of associated risk and detailed understanding of the risk connected to investment. A substitute for the basic credit default swap ratio comes by way of net leverage ratio that takes consideration of the net disparity between the negative and positive exposure to risk. For instance, on employing the basic credit default swap ratio, a group of bonds and stocks may be five investments with a positive ration of five and another five investments may have negative ratio of minus four. So, on the whole, the net leverage ratio should be +1.