Question

Are credit default swaps “financial weapons of mass destruction” as described by Warren Buffet? If so, why? Should they be regulated? How should financial institutions best use them? What are the pitfalls of credit default swaps? What are the major benefits? Do you have different answers for any of these questions for credit default swap baskets (CDX)?

Answer 1

It is true that CDS is one of the most important derivatives of financial market.

I.e in CDS 3 parties are involved bond issuer, cds buyer normally the bond buyer and cds seller , normally insurance co & bank like aig etc

here bond buyer will insure him self if the bond issuer default in such cas bond buyer will be compensated by the cds seller.

Need to regulate cds,:- as one can not buy fire insurance on other person home if the person but then such transaction will be void ab initio hence in this case the bond buyer insuring him self from default of bond issuer hence we need regulations to regulate the cds.

Pitfalls of credit default swaps

The main draw back of cds is if chain broken then everyone will be impacted, the same thing happened in 2008 where subprime debt issued by the lender and subsequently they default then whole financial system will be impacted , the main reason is we are not doing rating analysis of root debt from wich we are deriving value of cds

Major benefit of the cds is the issuer and bond holder both get confident about the financial market, liquidity not impacted due to any default, cds seller will get nominal fees throughout the tenure of the bond