Derivatives - Credit Default Swaps (CDS) Example

Essays on Derivatives - Credit Default Swaps (CDS) Essay Derivatives - Credit Default Swaps (CDS) Contents Contents 2 Credit Default Swap 3 Credit Default Swap and Systematic Risk 4 References 5 Derivativesare instruments which are used by investment bankers to allow traders to hedge their bets. Hedging protects banks and companies against unforeseen situations in case of sudden increase in value of commodities or currencies. Initially it was started with coffee or wheat which was subject to such kind of trading. Then options and swaps became the next common form of derivatives used by investment bankers. They were used by managers since individuals wanted to have the security of knowing at what price they can buy or sell the security, and wanted the chance of making profit when the market price is suitable to them. The next derivative instrument used by them is Swaps where exchange of currencies or interest rates is done. For example investment bankers can help an individual swap a floating rate of interest in exchange of fixed rate of in terest so as to minimize the risk (BBC, 2003, p. 1). Credit Default Swap Credit derivative is associated with any transaction whose value is derived from underlying asset credit worthiness. Credit default swap occurs when two private parties enters into contract with each other to share the risk in case a borrower fails to repay his loan. CDSs have similar features as both securities and futures but they are not classified as either of the instruments. Hence trading of CDSs occurs on a virtually unregulated and over the counter market. CDSs are seen as innovative financial instruments which have huge potential to transform the entire credit world. CDSs allow banks to hedge their risk effectively and thus banks can give more loans. CDSs provide greater latitude in creating risk profiles. The CDSs are traded in OTC markets and it permits greater customization of derivative instruments. Thus CDSs can be finely tuned so as to accommodate the accurate level of risk desired. Thus such customization helps decrease some risks involved in a transaction and thus in turn it provides room for more such transactions to occur. Credit Default Swap and Systematic Risk CDSs help reduce Systematic Risk. Prior to CDS, banks had to take all the risk of leveraging and thus they used to be exposed to high risk because of defaults which can happen anytime. Presently major participants of the financial markets have become intertwined and thus any risk of one player can have a liability on other players in another market. But CDSs have reduced the risks of leveraging because of diversification which brings down the damage to banks due to default. Thus banks which used CDSs to hedge themselves are protected from the exposure and loss caused by default since the cost associated with a default are borne or shared by each of the protection sellers with whom the bank had entered into contract (Reiser, 2009, p. 107). Thus by entering into CDS banks can decrease the chance of default and help mitigate the possibility of systematic risks. The contribution of CDSs to systematic risk is found in a term referred to as negative externality. Negative externality occurs when the behaviour of one market participant though beneficial to that market participant causes harms to other innocent market participants and the participant who causes the harm has no incentive to stop his behaviour. Thus regulation often is seen as the solution to the negative externalities which is controlled by CDS regulatory jurisdiction. References Reiser, A. 2009. An Economic Analysis And Legal Framework For Credit Default Swap Regulation. Available at: http://www.law.unc.edu/documents/journals/ncbank/balancesheet/aneconomicanalysisandlegalframeworkforcreditdefaultswapregulation.pdf. [Accessed at: 12 March 2014] BBC. 2003. Derivatives - a simple guide. Available at: http://news.bbc.co.uk/2/hi/business/2190776.stm. [Accessed at: 12 March 2014]