With our financial system in disarray, it seems that no one will give us a straight answer on what caused it. My goal in the next few blogs is to explain specifically what happened during the economic crisis, and how it happened. I am going to break down the world of high finance and derivatives down into digestible chunks of information and, more importantly, eliminate the fog of ambiguous and esoteric nomenclature by explaining just what all those fancy terms mean. In doing so we will all gain an understanding of the current economic crisis and its root causes.

Today I want to focus on the credit default swap. Over the past year you may have heard of this derivative and that it played a part in the financial crisis. But what is a credit default swap anyway?

A derivative is just something which has a value that derives from something else. For example, lets say you have a treasure map that shows the exact location of a $10 million treasure. Does the map have value? Yes and no. The map itself is just a piece of old paper, but the map makes it possible for you to acquire a $10 million treasure. You could then say that the map is worth $10 million, which is a value derived directly from the treasure. That's a derivative.

The financial world is chock-full of derivatives: futures, options, credit default swaps, etc. Continuing from the example above, let's say that the value of the treasure is constantly fluctuating. One day its worth $10 million, the next day it's worth $15 million. Wouldn't the value of the map fluctuate with it? Of course. Welcome to our financial derivatives market system. Substitute treasure with, stock, oil, etc bond and substitute treasure map with option, future, or credit default swap and you have a derivatives market that resembles our own.

So we now know what a derivative is, but what is credit default swap derivative? A credit default swap is really just insurance on an investment. The value of a credit default swap derives from the credit worthiness of the entity being invested in. Credit just refers to the extending of a loan. Default refers to someone not paying you back on a loan. Swap just refers to something changing hands. In this case the risk of default is what is changing hands.

Imagine if you were to loan a friend $100 and he agreed to repay you the $100, plus an additional $20 for giving him the loan (this is the credit part). That is $20 profit in interest. So you go through with it, but you soon start to notice your friend isn't doing well financially. You have a feeling he may not be able to pay you back (that's the default part). So you go to a credit default swap broker and you say to them "I will give you half of my $20 profit, if you agree to pay me back my full $100 if my friend goes broke". He doesn't believe your poor friend is really that bad off, and agrees. You are giving away some profit, but you are insured against any loss of your principal. You "swapped" the risk of your credit to somebody else in case they default. There, that is a credit default swap.

Credit default swaps are used all over the world in many different ways. You may be wondering why they became so dangerous. After all, now that we understand what a credit default swap is, it doesn't seem so risky and exotic, at least no more so than car insurance. Next time we will see just how things got out of control with the credit default swap.