In his book Bailout Nation, financial blogger Barry Ritholtz had this to say about AIG and credit default swaps (CDSs): Set all of the complexity aside, and at its heart a CDS is merely a bet as to whether a company is going to default on its bonds. According to AIGFP's [the financial division of AIG] computer models, the odds were 99.85 percent against ever having to make payment on a CDS.
a. What is a CDS?
b. How is a CDS similar to insurance?
c. Why might AIG's computer models have given an incorrect forecast of the likelihood of the firm having to make a payment on the CDSs they were selling? What was different about the housing market in the United States during the early 2000s compared with previous years, and how might that difference have been relevant to AIG?
d. Can a CDS be both a hedging or insurance instrument and a speculative bet?