Question

Why are banks interested to offer Equity Default Swap (EDS) to their clients? How do financial institutions writing/offering EDS make money?

Answer 1

Equity Default swaps are very similar to credit default swaps. The only difference is that the reference asset in case of credit default swap is a debt whereas in the case of equity default swap the reference asset is an equity stock. In case of credit default swap the seller of the product assures buyer of protection against default or any particular credit event, whereas in case of equity default swap, the seller of the product assures the buyer of protection in case the equity stock value declines below a certain percentage to the current price. In both cases the seller offers services against a series of regular payments similar to a premium payment made towards an insurance policy.

For example, the equity default swap might be entered into to provide protection to the buyer in case of say 40% decline in the underlying stock price from its market price at the time of initiation of equity default swap. These are technically similar to deeply out of money put options. This is considered by banks to be a high growth and lucrative avenue for improving earnings.