Welcome to the Credit Default Swaps Market

A credit default swap (CDS) is a contract which transfers financial risk from one party to another. In a credit default swap, the buyer pays the seller premiums over the lifetime of the contract, in exchange for the seller's assumption of risk.

Let’s say that Arjun borrows some money from Sikha. Sikha might decide that she doesn't want to assume the risk of default, so she approaches Jayati and negotiates a credit default swap. Sikha pays Jayati premiums in exchange for his assumption of the risk of the loan. If Arjun repays the loans successfully end of the contract period, the contract ends. If, however, he decides not to pay it, Jayati must pay Sikha the face value of the loan.

If Jayati turns around and sells the contract to Mayank and Arjun defaults on the loan, Mayank might not be able to repay Sikha. Mayank might even sell the contract to another party, making it difficult for Sikha to track down the holder of the contract in the event of default.

The concept of the credit default swap was pioneered by JPMorgan Chase in the mid-1990s, to allow banks, hedge funds, and other financial institutions to transfer the risk for corporate debt, mortgages, municipal bonds, and other credit instruments. By 2007, the market in credit default swaps had grown to Twice the size of the American stock market, and because this industry was largely unregulated, some serious problems began to emerge.

Trading in this credit derivative product began to be recognized as a problem in 2008, when several financial companies including the insurance giant AIG, Lehman Brothers realized that they were unable to cover their credit default swaps. And that’s link to the Global financial Crisis. Welcome to the Credit Default Swaps Market.==== Dr. Ratna Sinha