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Credit default swaps | Finance & Capital Markets | Khan Academy

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Introduction to credit default swaps. Created by Sal Khan. Watch the next lesson: https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities/credit-default-swaps-tut/v/credit-default-swaps-2?utm_source=YT&utm_medium=Desc&utm_campaign=financeandcapitalmarkets Missed the previous lesson? Watch here: https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities/credit-default-swaps-tut/v/credit-default-swaps-cds-intro?utm_source=YT&utm_medium=Desc&utm_campaign=financeandcapitalmarkets Finance and capital markets on Khan Academy: Interest is the basis of modern capital markets. Depending on whether you are lending or borrowing, it can be viewed as a return on an asset (lending) or the cost of capital (borrowing). This tutorial gives an introduction to this fundamental concept, including what it means to compound. It also gives a rule of thumb that might make it easy to do some rough interest calculations in your head. About Khan Academy: Khan Academy offers practice exercises, instructional videos, and a personalized learning dashboard that empower learners to study at their own pace in and outside of the classroom. We tackle math, science, computer programming, history, art history, economics, and more. Our math missions guide learners from kindergarten to calculus using state-of-the-art, adaptive technology that identifies strengths and learning gaps. We've also partnered with institutions like NASA, The Museum of Modern Art, The California Academy of Sciences, and MIT to offer specialized content. For free. For everyone. Forever. #YouCanLearnAnything Subscribe to Khan Academy’s Finance and Capital Markets channel: https://www.youtube.com/channel/UCQ1Rt02HirUvBK2D2-ZO_2g?sub_confirmation=1 Subscribe to Khan Academy: https://www.youtube.com/subscription_center?add_user=khanacademy
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Text Comments (201)
Marco Di Stefano (1 day ago)
Khan academy thanks for yours videos
Arjun Yadav (6 days ago)
Doesn't 1B dollars of assets set aside for 1T dollars of potential payout essentially mean that the probability of the company going bust is 0.001? So essentially 1T x 0.001 = 1B dollars? You could question the calculation of the probability though.
Fungai Simon (9 days ago)
thank you !
Samvit Agarwal (2 months ago)
This video was published at the perfect time
Peacefull Brown (5 months ago)
@Khan Academy: this is exactly the graphic resumy I was looking for CDS understanding! ;)
Matthew Sheffield (5 months ago)
Government is objective with regards to the financial industry? Hmmmmmmmmm........
F WB (7 months ago)
In your example, shouldn't AIG have a basic reserve, call it a rate of solvency or something that AIG must keep as a guarantee?
MarXs (5 months ago)
That -85% means (securities backed by mortgage, collateralized debt obligations and other toxic assets).
MarXs (5 months ago)
The -85% is reflected in their accounts generating disconfidence in the other contracts, so the Fed had to inject a large amount of billions to avoid contagion. Degrading even more the rating and losing capital value.
MarXs (5 months ago)
AIG have a risk coverage fund, but not the total amount of the transaction, 10/15% insured. But nobody expected the financial banks to put so much leverage into subprime mortgages, so in many cases the investment of 1 billion, meant losing 800-900 of the total. So the insurer had to face a hole of -85% of its balance to return to the pension fund.
kirsty adamson (7 months ago)
really clear and useful thank you
parteibonza (8 months ago)
Did the author of the Big Short (Michael Lewis) get some of his research from these videos? 0.o
Andy Owen (8 months ago)
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Mark Brent (10 months ago)
student loans... the next big short.. over 10% are delinquent...
Mark Brent (9 months ago)
thats what you think buddy...
Explicit Tech (9 months ago)
Mark Brent there is no value in owning those loans. Federal government also got their hands in it for less.
cecmanju (10 months ago)
i learned more from the big short than at school xd
Mankaran (11 months ago)
great and all but 2 mins of info in 10 mins
Navdeep Singh (1 year ago)
Lol this is a productive day for me. First the awesome Matt Damon narrated documentary, Inside Job, the the big short and then these vids. I love knowledge. ;)
Kenneth Mulongo (1 year ago)
I thought this video was great. Had no idea how CDS works but now I do. On top of that I also understand the massive risk with this! Thanks so much
TroyboyTv (1 year ago)
So were these funds limited by the rating companies and their ratings, or were they limited by basel II ? which one was the bigger factor in why they sought after the swaps
XForbide (1 year ago)
Somebody I think already asked this too. But if I'm the CDS seller and I will insure company A for 1% return annually, why not just have the CDS seller buy the bonds themselves then? Either way they company A goes bankrupt they have to pay the full bond price so I don't see why they wouldn't just buy the bond themselves such that they ge touch higher returns
XForbide (1 year ago)
ok thanks!
Lord Soros (1 year ago)
To buy these bonds I have to use my own equity, but selling CDS contracts doesn't require me to hold the reference product. When I sell CDS I can hold contracts worth more then my current equity/ capital. AIG would have $20 bn. in equity, but could hold $140 bn. worth of CDS contracts.
M's Compositions (1 year ago)
Government had to bail AIG the fuck out to save the us
Lord Soros (1 year ago)
$182 bn
Hadrien Croubois (1 year ago)
Why would AIG support the risk for only 1%/year when they could have bought A's bounds and get 10%/year ? Is it juste because AIG want's to keep its asset and can't just lock the 1B? If the 10% fee payed by B correspond to a 10% default probability, by asking for a 1% premium they are statistically losing money by covering the risk, while the fund makes 90% of the profit with no risk at all ... Makes no sense to me, but again, I only have a PhD and a good understanding of statistics and probability ...
Joseph Hartsock (1 year ago)
I'm just now learning all of this stuff so I could be wrong, but I think you're right in thinking that AIG doesn't want to buy A's bonds because that would indeed lock up 1B of their assets. If AIG doesn't have to designate any of their assets towards buying the bonds from various corporations, then AIG could indefinitely ensure investment firms for total amounts that greatly exceed their total assets. Also I don't think that the 10% fee paid by corporation B corresponds to their default probability, otherwise you'd be right in saying that statistically AIG would lose money. The only indication of a corporations default probability that we have is whatever rating is given to them by these private rating agencies.
Joey (1 year ago)
The federal government, namely the Clinton Administration, is responsible for the housing crash.
Simone Tanzi (9 months ago)
That, the previous Bush administration and the subsequent Bush Jr administrations
Eurodollartrader (10 months ago)
Finally someone understands reality.
Song Min (1 year ago)
This presentation was the most wonderful I have seen! so simple to understand. Thanks a lot!!!
Del (1 year ago)
Why are you assuming the government would be more objective with its ratings? The government's main business is being bought out by special interests, subsidizing, bailing out, picking winners and losers.
Sachin Dotel (1 year ago)
Why would AIG act as insurers when they can act as debt/loab brokers all they have to do is accept less interest rate maybe 25bp/50bp. Yeah they get less interest but they don't have to pay the pension funds back if other corporations defaulted. It's no risk for them while they're getting constant flow of money as long as the corporations are paying interest to the pension funds.
success maharjan (1 year ago)
this is great. it totally help me to understand the credit default swaps.
gersonmania (2 years ago)
There's no problem with private rating agencies. The problem is, when the government prevent new rating agencies on the market. Today's rating agencies became a cartel.
Tom Mills (2 years ago)
Question: I will use your examples to hopefully explain the question properly... Could a fund (CA pension fund) buy multiple insurance policies or CDS with different insurance corporations? Meaning if they loan $1B to Business A and insure that with a CDS of 1% of the 10% premium they are earning from Business A. Then do exactly the same thing with another insurance company (thus losing 2% of their 10% premium) doesn't this practically double the amount they have loaned should Business A default? As they will receive the $1B from insurance A, then another $1B from insurance B? Hope this question makes sense! Thanks!
Rodrigo G.C. (2 years ago)
These videos are amazing. There's room for improvement in the aesthetics but other than that they're very eye opening. Thank you for sharing this knowledge for free.
nice explanation. constructive critisim: script it next time!
Med Stud (2 years ago)
Hey Salmaan, could you please make a video explaining the' big short movie' and the big financial crisis in 2008? Thanks.
GD (2 years ago)
He already has. he has a whole playlist.
gordon sung (2 years ago)
no
Captain Obvious (2 years ago)
"Hey wait, wait, wait, AIG. You only have 100 billion dollars in assets, but you have insured 1 trillion dollars of other people's debts!" Lmao I laughed so hard at this.
unitor699 (2 years ago)
can i do a credit default swap
Aldo Lalo (2 years ago)
so basically the aaa is telling you its ok to give money to bb, which is moodys job to say if it is ok or not. how the hell can this happen is this even legal to begin with?
Lord Soros (1 year ago)
Its legal since The risk from the bb bond is transfered from the pension fund to the AAA Bank, and the only risk the pension fund is taking is liquidity risk of the AAA Bank, so the risk that AAA Bank cant pay you the insurance. But again they are rated as AAA secure, so the liquidity risk should be small.
SkISl0pE (2 years ago)
Saw the Big Short, now I'm reading the book, and I needed this video to understand it! Thanks Sal!
wazup3333 (2 years ago)
So what happens when corporation A defaults and AIG(insurer) cant cover the swaps?
Lord Soros (1 year ago)
Dodd-Frank Act provides guidance on security-based swaps rules, affecting credit default swaps under Title VII. Security-based swaps are defined as "securities" and now fall under the jurisdiction of federal laws, Securities Act of 1933 for ex. The Commission provided temporary relief from provisions of U.S. laws that allow the voiding of these contracts. They still can insure more then they have but with respect on the Basel 3 leverage ratios and liquidity standards.
wazup3333 (2 years ago)
are they more regulated now meaning they cant insure more than they have? What is the dod frank act all about 
David H (2 years ago)
+wazup3333 The securities would default and everyone would lose. Like if you bought insurance on your house and it burnt down but the insurer was out of money...bad luck. Not good.
wazup3333 (2 years ago)
what would happen if the government would not step in
David H (2 years ago)
+wazup3333 It happened...the government had to step in and pay it.
Julio Soto (2 years ago)
Great explanation. Thanks for freaking me out.
tamada woo (2 years ago)
watching [the big short] now. good lecture.
Abhishek Rattan (2 years ago)
came right here after watching big short
Abhishek Rattan (2 years ago)
+General Sarasota hahaha...... nah not literally :)
Captain Obvious (2 years ago)
+Abhishek Rattan all over your keyboard??
fordsucks27 (2 years ago)
bankers suck off insurance companies and insurance companies suck off bankers. it's a great big ol 69 and everyone one of us is getting thrown into the bukkake party. PRICKS
Well who the hell is rating Moody's ability to Rate!!!
Stars Are Angels (2 years ago)
+Durandisse84 Durandisse No one. Same with Standard and Poor's and Fitch.
Holy shit, from 6:45 to 7:10 Nails it all together guys.... but you gotta be patient and watch from the begining
Who paid Moody's to give such a Rating!!!!????? Ahhh Haaaa. Imagine AIG contacts Moody's.... We need you to rate our default risks!!! Now if Moody's give AIG a crappy rating, what are the chnaces that big money AIG calls upon them again?? Complete conflict of interest right there.
fordsucks27 (2 years ago)
nailed it. that's how business works. you rub my dick....I'll rub yours. we need third party companies to be established that can't be bribed or bought and absolutely without a doubt model their business on integrity and values, not just speak of it.
Not for nothing this is great. I needed this as I'm reading "The Big Short"
PornHubChairman (10 days ago)
Same. I watched the movie a year ago on Netflix and now I'm reading the book with a better understanding of things.
Peacefull Brown (5 months ago)
EXACTLY!!! that's the point!
jay parry (10 months ago)
Another fan of the movie here.
rolan nono (1 year ago)
"The big short" is an excellent movie! It explains how the world financial market got dragged into a crisis by the collapse of the US financial and housing market in 2007.
Pinaki Dey (1 year ago)
Same here lol
chandni rajguru (2 years ago)
Perfect !!!
Blaynery (2 years ago)
What if there is no default in the institution, and someone bought a naked CDS?
Jenny Nguyen (3 years ago)
Pretty awesome!! working for insurance company then u will get incredible bonuses.
TicallionStallion (3 years ago)
So American libertarians, conservatives, Ron Paul types; after watching this video, to prevent this scam from happening again we need less government regulation?  Kind of like the solution to a community with crime problems is fewer policeman to enforce the laws?
Michael Cromin (8 months ago)
Finally, some honesty.
norris pg (8 months ago)
then if both are greedy, as you say, then neither deserve to be bailed out and no hearts should bleed for them
Michael Cromin (8 months ago)
I think what Follow Media is saying is to have both the bail out AND increased regulation (to prevent future need for another bail out) and so have both short and long term benefits while you are advocating to do neither. There is greed on both buyer and seller side, which negates your argument of intelligent investors and careful banks. You are right that standards have not been kept, but standards will always take second priority to short term profits if there is no strict oversight from the government aka regulation.
norris pg (8 months ago)
if the marketplace is allowed to work (the institutions allowed to fail) those who are customers of them (pensions, govts.) will be more intelligent about what they are buying and, eventually, the marketplace would hold those institutions to such a high standard that the institution would not be able to sell its products without so much evidence guaranteeing the investment that it would be a stronger investment than if the U.S. taxpayer (government) was constantly bailing them out after an event...if the govt. continues to bail them out you WILL continue to "fall into the hole" as you call it because of moral hazard...you have to realize that the last few generations of institutional investors are much less intelligent about what they are investing in than, say, people of 4 and 5 generations ago, and that is because people who lived through the depression never forgot the lesson of loss after undertaking the risk associated with the stock market...lower interest rates necessitated by ridiculous debt enticed investors to chase yield and that means risk...they had not experienced great loss like the depression era people and, more to the point, were not held to a high enough standard by those who own the pension funds and the taxpayers who elect the officials who made the decision to buy those risky products...yours is a short term answer with long-term repercussion while mine is a short term sacrifice for a long-term benefit
Follow Media (8 months ago)
people don't seem to get that the american taxpayer or pensioner pays whether or not the bailout happens. they just suffer much longer without the bailout. apparently some are willing to let themselves and their neighbors and children suffer more just to see the bad guy go down, instead of get out of the hole ASAP and try not to fall into the next hole in the future. some weird cut-off-own-nose-to-spite-your-face logic going on here. also very strange to see comments about evil corporations being mentioned in the same breath as complaints about overregulation. it's quite obvious to a non US citizen that the problem is lack of regulation.
Gary Huang (3 years ago)
what if the BB rated corp weren't even able to pay for the 10 percent interest?Does the AIG also insure interest? Or it just insure principle?
Jenny Nguyen (3 years ago)
+黃建鴻 insured value should be USD1 B . i guess AIG would include some endorsement or exclusion on this high interest
p3tabyte (3 years ago)
Jesus - you ramble on and on. This video could have been two minutes long but unfortunately you like to, oh I dunno, let's just say, here yourself speak, right? Yep. Hear yourself speak. If you cut out all that stuff, like just cut it out, and let's say, I dunno, stick to the basics and be clear and concise, you could, let's say, cut this video down to like, how about like two minutes, ok? Like two minutes. Fuuuuuck.
fordsucks27 (2 years ago)
Let's say like..... if you don't have anything nice to say, then shut the fuck up.
DR Suarez (3 years ago)
i c u have fixed ur pen
Hiphop101ize (3 years ago)
WOW! The finance world is on some bullshit! Practices like this explain how the economy can collapse
Lord Soros (1 year ago)
CDS also had a positive effect on the economy, since they encouraged Invetments by taking the risk and keeping the markets liquid.
Maruf Yawari (4 years ago)
you are awesome, you should work as Fed chairman ;)
Eddy Allenby (4 years ago)
I fuking love you Khan!!! I lerned moore form you then i did from cummunity collage!!!
Andrew Kingsbury (3 years ago)
lmao. I hope you're spelling is intended to be a joke.
Ronald Mak (4 years ago)
Thank you.
Aira Kinney (4 years ago)
awesome thanks!
BeThe Rok (4 years ago)
nice man!
Ka-o-nabo P (4 years ago)
Simone, have you ever heard of an "allowance for bad debts"? I think it is implied that that's what AIG would need to set up. Of course the wouldn't pledge every asset.
Lord Soros (1 year ago)
An allowance for bad debt is a valuation account used to estimate the portion of a bank's loan portfolio that may ultimately be uncollectible. Lenders use the allowance for doubtful accounts method because the nominal value of a bank's total loan balance is not the actual balance that is ultimately collected, since a portion of the loans may default.
S. Whites (4 years ago)
but if AIG would set aside 1 billion it means that it has invested 1 billion at 1% = nosense. You set aside just a multiplier of that amount.
Free online education. Must watch videos... Very Cool.
Artin Honarchian (4 years ago)
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SP3NT (4 years ago)
Can you buy cds on something your not vested in?
vettefever67 (5 years ago)
We shouldn't even have ratings agencies.
Armando Rodriguez (5 years ago)
Good educational program for lay man. This was a scam, no matter how you put it. AIG could not cover the insurance. They fucked many citizens, and this will happen in 20 years again. If people continue to purchase what they can not afford. Tell me one thing. did AIG get bailed out? Yes they did, then they paid themselves alot of cash to the cocksucking CEO and staff. Lets see what happens next. Enjoy your day.
FillyChee (5 years ago)
what if Moody's goes out of business? haha.
Jcrazy 87 (5 years ago)
cool vidoes dude
Bo Manry (5 years ago)
I love your videos. Very helpful!
Nihao's It Going? (5 years ago)
Khan the man!
SunnyAG (5 years ago)
thank you! you made it so easy!
Jordan Agan (5 years ago)
love how you dont waste time with unnecessary prologue and get right to the point!!
Praveen Reddy (5 years ago)
This is very good and easy to understand
MsMichaela999 (5 years ago)
Absolutely love the khanacademy. Just when I though derivatives exam seemed pretty impossible, it all of a sudden all makes sense. God bless this lectures ;) Can you come and teach at our University?
sd diggler (5 years ago)
this is exactly what happened in Greece and the elite, germany , deutche bank and goldman sachs are making the poor people of Greece pay for it
JK Low (5 years ago)
The credibility of CDS depends on the Credit Rating. How ethical, honest and accurate are the ratings agencies?
Gouki (5 years ago)
Thank you so much for that. I'm a dummy so I didn't get anything from wikipedia or investopedia. But your video cleared it in once. Thanks a lot!
Phil.T.McNastee (6 years ago)
Like any financial institution,if every loan (or insurance) pays it's great. If a financial calamity occurs and enough big debtors go bust simultaneously then it is insolvent. So unless it has enough cash to cover EVERY single CDS, and it doesn't, it's technically insolvent.
Sean Mcloughlin (6 years ago)
Excellent! I never truly understood CDS's before this video.
Matt Fotsch (6 years ago)
It was assumed that very few CDO's/MBS would default due to their high credit rating. Meaning they could insure more than their total equity @KnowledgeableBucket
Matt Fotsch (6 years ago)
You make it sound like the credit agencies couldn't do a good job. It is true they blew the MBS and CDO markets. However, they were quite accurate on ratings for everything else. Essentially, they had issues rating Mortgages and their derivatives mostly, due to the reasons you spoke about in your housing bubble section.
twentysixstrings (6 years ago)
Thank you very much for this excellent explanation.
Chris Bailey (6 years ago)
Beautiful explanation
nimancait (6 years ago)
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E Zapata (6 years ago)
That was great. Thanks for the vid!
isaiasm21 (6 years ago)
@libelula202 The U.S. credit rating went from an AAA to AA rating in 2011. The video was made in 2008. C'mon!
Rui Jin (6 years ago)
Very useful tutorial. Clear and easy to understand. Keep it going.
jtebaize (6 years ago)
YOur video is really interessting, im french, and i really understand what you are saying. i was searching informations about CDS, and i found your video, thank you. And, oh, the world is fucked up!
deniskatashkentskiy (6 years ago)
that was fucking awesome dude!!! i love your style! don't change anything! keep it this way bro!
mavrick0ck (6 years ago)
thanks so much. this is such a clear tutorial on what a CDS is..
supralex1 (6 years ago)
So the best thing to do is to work hard, save your money, and put it in safe. Or hope a bank and the government will assure it. Or, put your trust in shysters. Great choices.
xcvsdxvsx (6 years ago)
"only the government would be objective enough" wtf, since when was the government objective, once representatives retire from politics where do they go? the corporate sector where they are rewarded for past compliance to private interest groups
malthus101 (6 years ago)
Excellent video, very clear now on what they are - I will watch your other videos! Thanks.
djguy100 (6 years ago)
Thanks for the upload
Troy McAvoy (6 years ago)
Wow, this helps a lot. This makes a lot more sense now.
Troy McAvoy (6 years ago)
@libelula202 this was done in 2008, three years ago...
44debil44 (7 years ago)
lehman brother had aaa before his crash...so, i give a shit to triple a or whatever
ian (7 years ago)
"Let's say I'm a pension fund" What the fuck is a pension fund? First sentence and I'm already lost
Nick Reynolds (7 years ago)
@treysparker What's deaf or blind got to do with anything? Stow that, please. What he says is not "absolutely against the free market." It's against absolute blind faith that the free market always doing what's best. We want accurate ratings. Can the gov't do that? Probably as well as Moody's. Can the gov't be corrupted? Certainly. But surely you see that being paid for ratings has the potential for abuse and at least the appearance of impropriety?
Nick Reynolds (7 years ago)
@PhilipNolan49 What personal political beliefs is he showing? Where does he indicate he disdains the free market, or believes the government is the perfect solution to every problem, or profits are wrong? Where is he moralizing? Not in this video. It sounds like your political beliefs are showing. The government is not to be trusted implicitly, but neither is the "free" market.
boskobosko (7 years ago)
corporation A = Greece!!
PhilipNolan49 (7 years ago)
Good job of explaining credit default swaps. That is very much appreciated. But it would be nice if you didn't allow your personal political beliefs to get in the way. It is clear you disdain the free market, believe the government is the perfect solution to every problem, and think profits are wrong. It is your video and you clearly have every right to express your opinions. I am just saying that it would be more effective to explain the concept without the moralizing.
49fiori (7 years ago)
how do you hedge between stock and CDS by going long on both? What does that mean. E.g. Paulson recently bought $1B HPQ shares, but the stock went down, so he could've also played relative value long CDS - what does this mean? Thank you!
RBaleog (7 years ago)
Financial terrorists should be treated just like other terrorists.

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