Credit Default Swaps Explained: How Can They Work For Me?
By William Finch on March 26, 2010, 6:00 am Posted in Business NewsIt is not possible to conceive how finance would work without credit. When most people hear the word credit, they usually think of credit cards, the most ubiquitous symbol of credit. The technical definition of credit is confidence in a purchaser’s ability to pay. Credit, in other words, is a financial expression of trust in a borrower. Note that credit does not necessarily refer only to credit cards. To be sure, credit card debt is a problem, but credit extends to a larger range of financial services: bonds, equities, loans and other financial instruments all deal with credit in some way.
Dealing With Debt
Debt is a somewhat misunderstood word these days. Spending money faster than said money is coming in is properly called a ‘budget deficit’ rather than true debt. Likewise, debt on a credit card is actually better described as a deficit, since you are not in debt if you simply spend more money than you make. Indeed, the whole notion of credit is built upon the belief of the extender of credit that you can cover the money that you spend with the money that you make. Sometimes defaults are unavoidable, despite the best of intentions on the part of the borrower.
Credit Default Swaps Explained
When a lender is faced with an impending default, the lender can utilize a financial instrument known as a credit default swap. They can be considered a form of insurance for the lender against the defaulting of the borrower. How they work is this: the buyer (the lender) pays a premium for the swap, and receives a lump sum if the borrower defaults. The seller, on the other hand, receives monthly payments from the buyer. If the original borrower defaults, the seller has to pay the buyer the agreed-upon sum that represents the amount of money lost by the buyer when the borrower defaulted. Credit default swaps can help lenders remain secure from the risk of borrowers defaulting.
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