So I just went and try to ingurgitate the wikipedia page on CDS.
Interesting read, if somewhat indigest.
One of the interesting take-aways is that if you buy a CDS, you
have multiple "interesting" scenarios, some of which include the
seller of CDS actually defaulting in case of a "credit event".
In other words, if you buy one of these, you might very well find
yourself experiencing the following:
- imsaguy defaults
- you turn around, claim a "credit event" has occured
- copumpkin disappears under cover of the night.
It comes down to evaluating the relative trust you have in either of these
two guys and hang actual numbers on that trust ... outlandish fun for all !
That's certainly an issue to keep in mind. By buying a CDS, you're not actually killing your risk as much as diversifying your exposure. Most people don't like to have a portfolio with only one security in it, because "all your eggs are in one basket". Similarly, if your entire risk exposure is from one borrower, that should make most people uncomfortable. By buying a CDS from someone (e.g., me), you're spreading your risk exposure across multiple people: if you own 1000 coins of debt from imsaguy and buy 500 coins of protection from me, you're now 50/50 exposed to me and imsaguy. Assuming imsaguy and I are uncorrelated (e.g., he isn't my brother or my partner in crime), other things equal, you're safer this way (and are paying me for the reduced risk).
Risk evaluation is a really hairy topic and there are entire departments at most financial institutions dedicated to measuring it and making sure people don't do stupid things. Things like (co)variance and correlation exist as imperfect measures of it, but their degree of imperfection can't really be known until it's too late
Risky business!
