Credit default swaps were originally created to serve as insurance for investors who had bought corporate bonds and were worried that the companies who issued those bonds would default. On the surface, credit default swaps seemed like a relatively tame insurance product. As with most financial instruments, however, speculators at hedge funds and other investment firms started looking for ways they could speculate on credit default swaps to increase their returns.

[VIDEO] Speculating with Credit Default Swaps

Speculators can use credit default swaps in one of the following two ways to try and boost their returns:

– They can buy credit default swaps on bonds they don’t own

– They can sell credit default swaps to others

You see, you don’t actually have to own bonds to buy a credit default swap. A large investor or investment firm can simply go out and buy a credit default swap on corporate bonds it doesn’t own and then collect the value of the credit default swap if the company defaults—without the risk of losing money on the bonds. It’s kind of like going out and buying life insurance on the guy down the street whom you have never met. You receive the payout if he dies, but you are not directly impacted by his death.

The problem with buying credit default swaps is you rarely receive a payout because companies don’t default all that often.

Selling a credit default swap, on the other hand, guarantees that you are going to receive money every year because the person buying the protection has to pay an annual premium—and that’s money in the bank.

Selling Credit Default Swaps

When an investor who is looking to hedge a position looks at credit default swaps, he looks at it from the standpoint of buying the credit default swaps to act as an insurance policy. On the other hand, when a speculator looks at the investing opportunities with credit default swaps, he looks at it from the standpoint of selling the credit default swaps to someone else and collecting the annual premium. Sellers of credit default swaps know that the premium, or spread, is going to keep coming in year after year after year, and they like the idea of that steady cash flow. Plus, companies with high credit ratings rarely—if ever—default on their bonds.

Now, you may be looking at this and wondering why that is a speculative move. Don’t insurance companies and large investment companies do just that? I mean, someone has to sell the credit default swaps if someone is going to be able to buy them, right? Here’s the thing. When an insurance company or a large financial institution is selling credit default swaps, they are selling many different credit default swaps. They have a diversified portfolio of credit default swaps to mitigate their risk exposure to any one credit default swap, and they typically also have much more capital in reserve. They are typically also not leveraging their entire financial foundation when they sell their credit default swaps.

When a smaller hedge fund or other small speculator sells a credit default swap, on the other hand, they are typically using extreme amounts of leverage because they don’t have the resources to make good on the insurance policy they have sold if the company on which they have sold the policy actually defaults on its bonds.

Leverage and Credit Default Swaps

Let’s start with a definition of leverage in the financial world. Leverage is the ability to control and take advantage of large sums of money when you only have a relatively small sum of money. Leverage usually involves borrowing money from someone else. Homeowners use leverage to buy a home when they take out a mortgage, currency traders use leverage when they post margin to buy a currency contract and stock short sellers use leverage when they borrow shares to sell on the open market. At any rate, here is how speculators use leverage with credit default swaps.

Imagine a hedge fund manager is looking to boost the fund’s returns for its investors, and he decides that selling credit default swaps is the way to go to bring in steady money. The hedge fund only has $1 million ($1,000,000) in assets, and the manager decides to sell credit default swaps to investors who are looking to hedge $100 million ($100,000,000) worth of bonds. In the credit default swaps agreement, the bond investor agrees to pay a spread of 3 percent, or $3,000,000, each year to buy the credit default swaps. This is a great return for the hedge fund manager. The fund receives $3,000,000 every year—which equates to a 300-percent return on investment ($3,000,000 / $1,000,000 = 300%). That’s not too shabby. There is only one problem. If the company on which the credit default swaps is written ever defaults, the hedge fund manager will owe the credit default swaps buyer $100,000,000—and that is $99,000,000 more than the hedge fund manager has. If the company defaults, the hedge fund manager will also have to default on his credit default swaps.

That is some serious leverage. The hedge fund manager is able to make profits off of $100 million while only having $1 million in the fund.