Discussion - What is a credit default swap (CDS)

Discussion Post

Answer the questions below by using the file for reference and information:

• 1) What is a credit default swap (CDS)? Consider the cash-flow pattern of the CDS in Exhibit 2 of From free lunch to black hole: Credit Default Swaps at AIG  Can you set up a trading strategy using long and short positions of the default-free floating rate bond and the defaultable floating rate bond that replicates the cash flow pattern of the CDS? Given the coupon rate on the defaultable floating rate bond, can you determine the CDS rate based on the law of one price?
• 2) Review Exhibits 3-6 of From free lunch to black hole: Credit Default Swaps at AIG. What was AIG's role in the process of mortgage securitization? How did the Bistro deal work? How does the mortgage securitization work? What are super-senior tranches and what is their purpose?
• 3) How risky are BBB-tranches in the first layer of securitization?
• 4) How risky are super-senior tranches in the second layer? Should one view a super-senior tranche as safer than an AAA-rated corporate bond?
• 5) Is it possible that AIG could experience big losses on its super-senior CDS positions? Are collateral calls justified?