As part of a game I will release, I will offer Credit Default Swaps (CDS) and Credit Event Binary Options (CEBO). These are topics that are obscure since they are unwieldy financial tools to deal with investment risk. Collectively, massive risk can be incurred and an industry can be taken down sic 2008 financial crisis.
If you watched "The Big Short" then you are familiar with the term Credit Default Swaps, but have no clue how they work. Simplified in the movie, it is a way for you to short debt obligations. A mortgage is a debt obligation and if you have no belief in the creditworthiness in a party to that obligation then you want to SHORT that entity.
For every credit default swap, there are two counter parties, a buyer and seller, and a reference debt. You, the buyer, want to purchase "protection" against the default, a credit event, on a debt (loan/loans/pool of loans/etc). When you buy protection you will have to pay premiums, just like you do with insurance, to the willing seller. In the case of the debt obligation going into default, the seller will pay you whatever you agreed to minus the premium. If a default doesn't occur, the seller keeps the premium. Obviously the contract lasts for a finite period.
The seller will typically be an institution, because of the counter party risk associated. Counter party risk here for you as the buyer is that the seller cannot pay you when the credit event, default, has occurred. This could happen if the seller was too exposed or over extended and has to default on their debt with you. You lose the premium and the potential gains in that scenario.
The seller would typically sell a CDS if the risk of default is low. If the risk of default is high then it is a high stakes scenario and you will pay more premium to the seller assuming the seller has a high risk tolerance. Payouts of CDS can be really really high. Your premium could be 100k while the payout could be 2-5million in the event of a default, so it is not surprising if a seller doesn't have a high risk tolerance.
I knew some specifics about CDS before, but the idea of it being a protection confused me. ChatGPT clarified it for me. 🙏
So I wanted to know how is it considered protection when the buyer could have no connection to the referenced debt i.e. speculator. Like what is the CDS protecting really?
Let's say like in 2008 where if you invested in Mortgage Backed Securities which are a pool of mortgages and you wanted to hedge against defaults. Well, you can use a CDS to protect against historic defaults like in 2008 and lose against your MBS but gain against your CDS. You've mitigated total loss. You were long mortgages and short mortgage industry. Here, you are being a prudent investor.
Now if you aren't exposed to the negative impacts of underlying debt at all, you are a true speculator. You are just there betting against entities or industries.
A CDS is for large net worth investors. A CEBO is a true retail speculator's instrument where you are trading against a credit event. It's like Binary Options which is where you say yes or no to a condition (such as greater or less than) on a stock price at a certain time. CEBO is more like yes or no to default on debt or bankruptcy of a company and at a fixed amount during a fixed time. A CEBO eliminates counter party risks and is trade-able on exchanges just like any old options contracts.
Would I have traded CEBOs on some "meme" stocks? For sure. Just look at BBBY now. Its financial sheet has been trash.
I like the way ChatGPT explains these concepts and how I can ask it follow up questions to gain more understanding of these two exotic financial derivatives, so I can implement them. I asked it various question around a CDS being protection, what is it to a speculator and counter party risk. Call me impressed that it explains it so well.
My hope is that this asset market game becomes a vehicle for more people to get interested in stock and derivatives trading with real money. Trade like the rich!
Who knows, maybe Goldman Sachs or JPMorgan will offer to buy the game from me >_>. Maybe they are better suited to operate it anyway. My depth of financial instruments is limited and will remain limited since I am not privy to all the machinations that these financial demons come up with. There are some options offerings I made up as well, so that will be interesting to see if players use them.