Financial eduacation - CDS

[stolen_tea]

Could someone who understands these things better than I, explain to me how a credit default swap is different than a gamble

Comments

[r_ness]

I was intrigued by your question, so I thought I'd google.

Here are a couple of the pages I found:

http://gregcohn.com/blog/business-models/2007/02/a-ramble-on-gambling-vs-insurance-and-a-fun-quiz/

http://blog.worldvillage.com/business/insurance_is_not_gambling.html

The second link seems to agree with this excerpt from Wikipedia:

"Because contracts of insurance have many features in common with wagers, insurance contracts are often distinguished under law as agreements in which either party has an interest in the "bet-upon" outcome beyond the specific financial terms. E.g.: a “bet” with an insurer on whether one's house will burn down is not gambling, but rather insurance - as the homeowner has an obvious interest in the continued existence of his/her home independent of the purely financial aspects of the "bet" (i.e., the insurance policy). Nonetheless, both insurance and gambling contracts are typically considered aleatory contracts under most legal systems, though they are subject to different types of regulation."

(http://en.wikipedia.org/wiki/Gambling)

Dunno if that helps.

[stolen_tea]

Aha, it comes of reifying risk.

Gambling is when one moves from a state of no risk to a state of rare-good risk, while insurance is when one counterbalances an existing state of rare-bad risk with an equal and opposite rare-good risk, which is, in turn, someone else's rare-bad risk.

So if a gangster were threatening to extort money from you if Chowder Bowl won the race, it would more or less be insurance to put a big enough bet on Chowder Bowl to win, that you'd be compensated if that happened.

[dymaxion]

Yes. There's a further concept of "moral hazard", which is the state where the insured party's loss in the face of an insurance payout is sufficiently smaller than the amount of the insurance such that it becomes in their interest to collude towards the triggering of the payout. Insurance transactions must prevent moral hazard, whereas more traditional investments (and gambles) do not have that requirement.

[lumiere]

And a government bailout for bad business dealings presents a risk of moral hazard, both at the current time and in the future.

[dymaxion]

....offset by the convenience of having a viable US banking industry. There's no question that a bailout is absolutely mandatory from an economic perspective. What will make it good or bad is what we get in exchange for the money, and what's done to prevent it from happening again.