What is a credit default swap contract? This is the explaination

What is a credit default swap contract? This is the explaination

What is a credit default swap contract? Maybe for many of you who don't understand what a short is on the home market in the form of a credit default swap and indeed this credit default swap contract is very complicated, so I try to explain it as simply as possible, if you have any questions, please leave them in the comments column.

Now I will explain a little about the credit default swap before I go in to explain in more detail what Dr. Michael Burry. So the credit default swap contract is basically a type of derivative contract. If you ask why a credit default swap contract is included in a derivative contract or any type of derivative contract, I will explain later. And in a credit default swap quote contract used in the form of a basis point. Or commonly abbreviated as BPS. For 1 bps is equal to 0.01%. So if I later say the commission charged is 100 bps that means it is equal to 1%.

OK, now let's get to the point. So as I explained in my article entitled credit default swap, that credit default swap always involves 3 parties, namely investors, invested instruments such as bonds, stocks, contracts and others and thirdly there is an investment bank or insurance company. Dr. Michael Burry, he played the role of insuring the CDO which he thought would fall and collapse and he came to Goldman Sachs where he acted as an investment bank to make a credit default swap contract.

But this explanation is different from my explanation regarding the credit default swap. Because in this case Dr. Michael Burry does not insure his investment in CDO A, but he insures only for the failure of CDO A, or in the film's term called not insure but short against the home market in the form of a credit default swap.

Well now I will give an example of a simple calculation with assumed numbers, so now Dr. Michael Burry wants to make a credit default swap contract against CDO A and he comes to Goldman Sachs and then Goldman Sachs will assess how vulnerable or how likely it is that the CDO A offered will fail or commonly known as the probability of default. Then Goldman Sachs will call a number like 500 bps annually. Now that figure is a premium that must be paid annually by Dr. Michael Burry at Goldman Sachs so this is almost the same as the car or jeep insurance you have, the difference is that for credit default swap contracts there is a market for buying and selling the contract.

So in this case Dr. Michael Burry didn't have to wait until the CDO A collapsed. In this case the initial contract value of the credit default swap is the same as the premium of 5%. If CDO A continues to show signs of failure and its investment rating continues to decline, the probability of default of CDO A will also increase.

Well from here Dr. The new Michael Burry will benefit. So now the probability of default from CDO A to 750 bps or 7.5%. So Dr. Michael Burry has 2 options, namely selling to other investors or reselling to Goldman Sachs. Whichever Dr. Michael Burry will benefit from the difference between the initial premium and the current probability of default. So Dr. Michael Burry if selling the contract is 750 bps subtracted by 500 bps or equal to 250 bps multiplied by the value of the investment. Or for example, the investment value is 100 billion dollars multiplied by 2.5% so the profit is equal to 2.5 billion dollars.