Securitization Case Study
Securitization is the process of creating, through financial engineering, an illiquid asset into a security. Subprime Loans are examples of illiquid assets. During the process, loans are put together as a pool, held as the collateral of securitization and then transformed into securities.
The common knowledge indicated that leverage was necessarily and directly correlated with improving in returns. Nonetheless, the theories …show more content…
There is then, risk in loss of value of collateral assets, and increasing opportunities of deep failure if there is market liquidity going down (or prices decreasing). When and if market liquidity falls, there is a direct relation between leverage level and loss level.
To understand better the process of securitization, there is a need of comprehending the main players. On one side, the originators are the beginners of the securitization process by gathering a series of financial assets, then these assets are sold or transferred to SPV.
The SPV then sell the securities which are backed by the assets held in the SPV, to investors. Cash flows are later transferred to investors. SPV are Special Purpose Entities, this means subsidiary companies designed to serve as a counterparty for swaps and other sensitive derivative instruments. They are mainly used to isolate financial risk, what can become a devastating way to …show more content…
Typically, the duration of a CDS is five years, and this is how it works:
• Part A periodically pays a sum to Part B
• Part B agrees to reimburse Part A the title's face value if the debtor C goes bankrupt.
Shortly, A has bought the bond issued by C, but A wants to be sure that C will repay the capital at maturity
For instance, if the value of the purchased securities is €100,000, and the cds is 120 basis points, that means that A has to pay €1200 every year in order to be sure of the refund.
The "premium" received or paid to exchange a CDS contract is equal to the "spread" (the differential yield between the Interbank rates).
The CDS aims to transfer the credit exposure of fixed income products between the parties and is, therefore, a credit derivative contract. As anticipated, this is a kind of hedge insurance for the protection buyer.
The benefit for the protection seller is to assume positions over a period, perceiving their profits without financing them. Obviously, the more the CDS market gets worried by the insolvency of the buyer, the more the seller will increase his