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ABSTRACT
Though accused by critics of helping to cause the current financial crisis, credit‐default swaps are blameless. The accusation is understandable, however, given misunderstandings about how a credit‐default swap actually works. A careful look into its mechanism shows that it is not only simpler than thought, but that it is also vital to keeping the financial system strong by enabling financial institutions to better manage their risks. The risk taken on in a credit‐default swap (CDS) is no different from the risk of making the underlying loan. CDSs allow risks to be spread more widely instead of being concentrated at vulnerable points, but they do not add to the total amount of risk.
Notes
1. The term “insurance” is used here in its broadest sense, as protection against loss. Credit‐default swaps are not insurance in the strict sense—the service provided by insurers of life and property. Insurance of that kind is an actuarial, not a credit activity, and depends on an understanding of the likelihood that losses will occur to similar pooled risks, not to a specific insured party.
2. Editorial, “Bear's Market,” Wall Street Journal, 4 April 2008.
3. An excellent discussion of the role of credit‐default swaps appears in Mengle Citation2007.
4. Depository Trust and Clearing Corporation, “Trade Information Warehouse Data,” week ending 12 December 2008. www.dtcc.com/products/derivserv/data_table_i.php