Can you explain Credit Default Swaps?

Overnight Indexed and Credit Default Swaps

• Answer the following questions clearly and briefly, using your OWN WORDS: 1.Describe the turnover of swaps in the Australian Over The Counter (OTC) market. 2.Compare the features of overnight indexed swaps to that of plain vanilla, fixed-for-floating interest rate swaps. What are the uses of overnight indexed swaps? 3.Describe the features and uses of credit default swaps. The Answer should base on the following links and ensure they are properly referenced throughout the answer. The answer SHOULD NOT exceed 500 words in total. ?Australian Financial Markets?, RBA Bulletin, June 2002, pages 12-13 and 21: http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jun02/bu_0602_2.pdf ?Overnight Indexed Swap Rates?, RBA Bulletin, June 2002: http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jun02/bu_0602_3.pdf ?Credit Risk Transfer Markets: An Australian Perspective?, RBA Bulletin, May 2003: http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jul03/bu_0703_2.pdf Cheers, Maietto.

• Answer:

  The turnover in swaps in the Australian OTC market has increased by almost a factor of 6 from 94/95 to 00/01, rising from about 1 billion Australian dollars per day to almost 6 billion Austrian dollars per day (?Australian Financial Markets?, RBA Bulletin, June 2002, page 13). Increased demand for private bonds is credited with fueling the turnover in swaps because private bond investors hedge their positions using swaps. The launch of two new swap products has also increased the overall turnover volume. While credit default swaps have experienced limited turnover so far (only 28 billion Australian dollars annually for 00/01), overnight indexed swaps, which first became available in Australia in late 1999, averaged 2 billion Australian dollars of turnover per day in 00/01 (?Australian Financial Markets?, RBA Bulletin, June 2002, page 13). Overnight indexed swaps are a specialized form of fixed for floating interest rate swap, which are financial instruments used by two parties to exchange a floating-rate payment for a fixed-rate payment. For an ordinary fixed for floating interest rate swap, the floating-rate payment is based on a predetermined benchmark, typically the 90-day Bank Bill Reference Rate. In contrast, overnight indexed swaps use the Reserve Bank of Australia overnight cash rate as their benchmark. Overnight indexed swaps are also generally of much shorter duration than ordinary fixed for floating interest rate swaps, ranging from one week to no more than one year. In addition, unlike ordinary fixed for floating interest rate swaps that involve a stream of payments, overnight indexed swaps consist of only one payment when the swap matures. The payment reflects the total amount owed by one party to the other based on the interest rates that prevailed during the life of the swap. Banks and other financial institutions limit their exposure to changes in the overnight cash rate by employing overnight indexed swaps. Unlike bank bills, overnight indexed swaps have minimal credit risk because no principle is exchanged, which makes swaps especially attractive for this purpose. Credit default swaps are contracts that are purchased by one party from another to protect against adverse credit events occurring with a defined third party. Banks and other financial institutions usually use these swaps. The protection buyer pays the protection seller a premium at regular intervals based on the amount of protection purchased. In the event the third party experiences an adverse credit event, such as bankruptcy, the protection seller pays the protection buyer the purchase amount of protection. In return, the protection buyer gives the protection seller a debt instrument, typically a bond, issued by the third party. To maximize the value of the credit default swap, the protection buyer will provide a bond to the protection seller that lacks credit wrapping because such bonds will have declined the most in value in response to the adverse credit event. Credit default swaps allow the protection buyer to protect itself against credit risk by purchasing protection that increases in value when a defined third party decreases in creditworthiness. Sincerely, Wonko