Could someone pls. explain the following in simple words: “There is no cost to the seller of the credit default swap which increases their exposure to credit risk thus leveraging their position” Leverage how?
I assume it is based on the fact that you: a) own the credit asset, and b) sell the CDS on the same asset In effect you have doubled your credit exsposure of the asset - if the bond defaults you lose your investment in the bond and you also have to pay out to the buyer of the CDS
Thanks newsuper, I think that got me thinking now and just to clarify here, Doesn’t the seller just act like an insurance company? How does he end up owning the asset? He would just assume the credit risk and his position is levered up due to the potential default of the bond, right?
yeah the seller acts like an insurance company, but he can also own the asset. Think of it this way - you own your house and you sell insurance against it burning down: if your house does burn down you have lost your house and you also have to pay up to whomever bought the insurance from you. so why would you both own the home and sell insurance against it? Myabe you think your house is fireproof and this might be a neat way to make some extra cash…so you have effectively doubled up on your risk exsposure.
Oh gotcha gotcha !!! Made sense…thanks a lot …