Question

Describe an example where a bank could control their risk exposure to a counterparty or asset class using Securitized instruments such as CDS or MBS.

Answer 1

The banks use CDS in order to mitigate their credit risk exposure to a particular firm or asset. So by using CDS without transferring the underlying asset, the bank generally transfers the risk of the first party or client to another party.

CDS are the negotiable bilateral contracts (reciprocal arrangement between two parties to perform an act in exchange of the other parties act) that help the users to manage their exposure to credit risks. The buyer pays a fee to the party taking on the risk.

An example is:

Suppose Bank of America buys a bond which issued by a Microsoft Company. In order to hedge the default of Microsoft Company, Bank of America buys a credit default swap (CDS) from Insurance Company AIG. The bank keeps paying fixed periodic payments to the insurance company, in exchange of the default protection.