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

[craigp]

unless you can eliminate risk by "arranging" for a government bailout, much like fixing a fight. it's how organized crime, erm, smart businessmen, roll.

[r_ness]

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

[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.

[cerebralpaladin]

Yeah. As I think you have figured out, it is a gamble, but gambles can be a good thing because they allow the shifting of risk. That can be positive, because A) if you are exposed to risk, you can shift some of that risk to somebody else and B) if you are not exposed to risk, but you have a high risk tolerance (like, say, an insurance company), you can take on risk from other people. The obvious problem, of course, is if a low-probability event will result in you losing money on many many bets simultaneously, in which case you go broke, default on the swaps, and shift lots of risk back to people who thought they had hedged it away.