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Ten Benefits Of Synthetic Credit Default Swap That May Change Your Perspective | synthetic credit default swap

Yes, a second being the Markit PrimeX, a synthetic credit default swap (SCF) index referring to a basket of worldwide prime mortgage-backed derivatives. Its original intent was to: make a more liquid, tradeable instrument allowing investors to take positions in worldwide mortgage-backed derivatives through CDS contracts without having to deal with the complexities of paper trading. However, this type of derivative is much more complex than originally conceived, and at times is a very complex financial tool. In fact, even the definition of what a synthetic derivative is today can be considered an over-simplification. The actual definition of a synthetic derivative is: a financial product, asset or security which is not fully correlated to any particular money supply, and is not expected to become correlated due to changes in policy or interest rate.

So what are synthetic credit default swaps? They are financial products that allow mortgage-backed borrowers to convert their mortgage loans (i.e., the “collateral underlying”) into cash that is automatically deposited into an account by the broker or dealer. Essentially, the broker or dealer receives a fee for allowing this cash to be deposited. Although these contracts are not actually “tangible” assets, they can only be owned by the mortgage lenders themselves. It is important to note that when these contracts are converted from “collateral underlying” into cash, the actual asset, i.e., the mortgage loans themselves are changed, creating an asset for the lender.

The synthetic credit default swap is designed to provide mortgage lenders with protection in the event that the markets begin to experience turbulence. This is done by ensuring that the mortgage lenders have access to the “custodial funds” which are ultimately deposited into trust accounts controlled by the brokers or dealers. The idea here is that if the markets begin to decline, the mortgage lenders can access the Custodians of Trades and Settlements and access the cash in these accounts. In this way, the mortgage lenders are able to mitigate their risk in the event that the markets become unstable. Traders and investors in turn will be protected from the losses that they may incur should the markets continue their decline. This is basically the same concept that exists in “put buy and hold” strategies that are used by some investment firms and hedge funds to mitigate their exposure to the underlying stock market.

There is one major difference between synthetic credit default swaps and “put buy and hold” strategies which are utilized by some private investors and institutions: whereas hedge funds typically focus on trading particular debt obligations, the synthetic credit default swap is employed to mitigate overall credit risk within the mortgage market. Therefore, it is for this reason that hedge funds tend to purchase large amounts of these types of debt obligations. Private investors typically just work with small and medium size mortgage financing institutions as well as shadow banking systems. As these two sources of funding are relatively liquid and have access to a wide variety of debt obligations, most synthetic credit default swaps are used within the cash flow hedging arena.

When these mortgage securities are purchased by an investor, it does not necessarily mean that the investor is purchasing the actual instrument, such as a bond. Rather, it means that they are purchasing the rights to purchase those bonds. In doing so, there is typically an assumption that the risk of holding the underlying instrument is minimized. For instance, when an investor purchases mortgage securities from a bank, there is no assurance that the interest rates will remain low. However, the bank has the right to sell these securities at a certain date in the future. If and when interest rates rise, the bank will be in a better position to absorb the losses associated with the bonds.

The concept of synthetic CDs is relatively new and is only available to accredited investors. With synthetic CDs, an investor buys the right to exchange the underlying treasury note or mortgage-based securities for another note, usually a debt obligation. Typically, investors who purchase mbs securities expect interest rates to rise significantly over time. To capture this benefit, many investors purchase the bonds themselves, then sell the note for a profit once interest rates have risen. However, since banks do not need to purchase these mortgage securities in the first place, these instruments do not have the additional cost of marketing to financial institutions and receive a profit. For these reasons, synthetic credit default swaps are appealing to investors who are seeking to use alternative financing sources but do not want to commit to holding mortgage securities.

Because of the significant benefits associated with synthetic credit default swaps, many financial investors choose to purchase these instruments on a regular basis. In fact, many investors use these products as their primary source of short-term funding, using them to make purchases against credit card debt, bridge loans, and other similar short-term financing options. Derivative products also provide investors with additional tax advantages, as well as various options when it comes to creating derivative products that benefit the entire company.

The attractiveness of a synthetic credit default swap is both its simplicity and flexibility. One of the reasons why synthetic products are attractive to investors is that they do not require the same upfront costs as conventional derivatives. Derivatives such as credit default swaps are not typically “listed” on the financial statements of the issuing company. This means that an investor does not need to hold assets in order to gain exposure to the credit default swap; therefore, the investor need not be concerned with how he will fund his purchase and how he will compensate a loss should the issuer fail to pay. Additionally, because these instruments do not need to be listed on a company's balance sheet, they offer investors a unique opportunity to obtain additional funding sources without the additional expense of securing a loan from a traditional financial institution.


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