Declining Terms of Trade

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decline-in-terms-of-trade

The Terms of trade refer to the relative price of exports/imports. A decline in the terms of trade means the price of exports falls relative to imports. Imports become more expensive. Typically a country will have lower living standards and less ability to import. Impact of decline in terms of trade on a developing economy …

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Effects of a budget surplus

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A budget surplus occurs when government tax receipts are greater than government spending. It means the government can either save money or pay off existing national debt. It is worth noting, that budget surpluses are quite rare in the past 120 years. Politicians have sometimes attempted to enshrine budget surplus into law but what are …

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Credit Default Swaps Explained

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Definition of Credit Default Swap – CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage-backed securities, corporate bonds and local government bond

  • The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument defaults.
  • The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.

Example of Credit Default Swap

  • An investment trust owns £1 million corporate bond issued by a private housing firm.
  • If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
  • The investment trust will pay interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
  • If the private housing firm doesn’t default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
  • If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million – the value of the credit default swap.
  • Therefore the hedge fund takes on a larger risk and could end up paying £1million

The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Example of Credit Default Swap

  • Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a £1,000 bond.
  • Lloyds TSB may then purchase a credit default swap from another company e.g. a Hedge Fund.
  • If the firm (Riskymortgage.co.uk) default on the loan, then the hedge fund will pay Lloyds TSB the value of the loan.
  • Thus Lloyds TSB has insurance against loan default. The hedge fund has the opportunity to make a profit, so long as the firm does not default on the loan.
  • The riskier the loan, the higher will be the premium required on buying a credit default swap.

Why Would People Buy Credit Default Swaps?

1. Hedge against risk. Suppose an investment fund owned mortgage bonds from riskymortgage.co.uk. It might be worried about losing all its investment. Therefore, to hedge against the risk of default, they could purchase a credit default swap from Lloyds TSB. If riskymortgage.co.uk defaulted, they will lose their investment, but receive a pay-off from Lloyds to compensate. If they don’t default, they have paid a premium to Lloyds but have had security.

2. Speculation e.g. risk is underpriced.

Suppose a hedge fund felt risky mortgage was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt defaulted, then they would make a profit from Lloyds TSB. Note you don’t have to actually own debt to take a credit default swap.

The riskier a bond is the higher premium will be required from a buyer of a credit default swap. It is argued that credit default swaps provide an important role in indicating the riskiness/creditworthiness of a firm.

3. Arbitrage

If a company’s financial position improves, the credit rating should also improve and therefore, the CDS spread should fall to reflect improved rating. This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy. Arbitrage could occur when dealers exploit any slowness of the market to respond to signals.

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Population density

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victorian houses

Population density is the average number of people living per square mile/km. A high population density implies that the population is high relative to the size of the country. Countries, such as Belgium and the Netherlands have a high population density. Large countries, such as Australia and Canada have very low densities. Though this low …

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Size of Labour Force and Working Population

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economic-inactivity

Readers Question: why is there a difference between the size of the population of working age and the size of the workforce? The population of working age is everyone between 18-65. The workforce is everyone either in work or actively seeking work. This is also known as the numbers economically active. The workforce excludes some …

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Economic growth per capita

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Economic growth per capita looks at the average increase in real GDP per person. We could have economic growth of 3% a year. But, if population growth is also 3%, then average incomes – Real GDP per capita will remain the same. If the population declines by 2% a year, but real GDP increases 1% …

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Winners and losers from a weak Pound

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The Brexit vote has led to sharp fall in the value of the Pound, at one stage falling to £1 = $1.22 – a fall of over 15%. This will have a significant impact on British firms, consumers and also those outside Europe. In short: Winners from weak Pound UK exporters who will be more …

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Interest Rates and Balance of Payments

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Readers Question: Interest Rates are increased by the governments to bring down inflation rates, this makes exports price competitive as well, as a result, exports increase. However, an increase in interest rates can lead to an appreciation of the currency as demand for the currency increases. So this again increases the price of exports as …

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