By Angus Maguire
Credit default swaps (CDS) are the most commonly used type of credit derivative. (Credit derivatives are privately held contracts that allow users to manage their credit risks; the price of these contracts is driven by the credit risk associated with them.) Credit Default Swaps were first created in 1995 by JP Morgan and quickly accelerated in use; there were $62.2 trillion dollars in these contracts by the end of 2007. To put that in perspective the US Nominal GDP in 2007 was $13.794 trillion. Credit default swaps usually work when a large bank, or investment firm sell a CDS to an individual or firm who would like to insure a risky bond. In exchange for the seller promising to pay back how much the bond is worth if the company who issued the bond defaults on the bond the buyer will pay a percentage of the bonds dividend occasionally over the period of the bonds life. If you don’t understand refer to the diagram below.
Credit default swaps (CDS) are the most commonly used type of credit derivative. (Credit derivatives are privately held contracts that allow users to manage their credit risks; the price of these contracts is driven by the credit risk associated with them.) Credit Default Swaps were first created in 1995 by JP Morgan and quickly accelerated in use; there were $62.2 trillion dollars in these contracts by the end of 2007. To put that in perspective the US Nominal GDP in 2007 was $13.794 trillion. Credit default swaps usually work when a large bank, or investment firm sell a CDS to an individual or firm who would like to insure a risky bond. In exchange for the seller promising to pay back how much the bond is worth if the company who issued the bond defaults on the bond the buyer will pay a percentage of the bonds dividend occasionally over the period of the bonds life. If you don’t understand refer to the diagram below.
The problem with Credit Default Swaps is that there is no guarantee that the seller of the CDS will be able to fulfill their side of the contract if the buyer of the bond needs to be reimbursed if their bond defaults. The other problem is that CDSs are unregulated; when the banks or investment firms sell CDSs they do not need to pay anything to do this. In selling the CDS, the seller merely promises that they will pay if the bond defaults. Many more Credit Default Swaps were sold than can actually be reimbursed meaning that in the recent collapse of many financial institutions many CDSs have had to be paid back by other financial institutions, leading them to lose even more money therefore helping the downward spiral in the financial sector.
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