Question

Explain the concept of Credit Default Swap (“CDS”), how it evolved over time and the role it played in the 2007-08 financial crisis. (1500 words)

Answer 1

Credit Default swap is a kind of swap in which you take insurance of bond by making payment to someone who will pay you in case of default in payment of bonds.Here ownership of bond is not necessary for entering swap and people can speculate on such bonds on which they think companies will be in trouble in future.

Role of credit default swap in 2007-08 financial crisis.

In 2008 when there is default in payment of bond by Lehman brothers due it's bankruptcy it causes several problem in the country.As insurance companies has sold several CDS to various companies and various companies has made investment in CDS expecting default in bonds.When there is default the insurance company doesn't have sufficient money to repay all the companies holding CDS even their investment amount because of huge number of CDS were sold and insurance companies doesn't have that amount of money to repay inncase of failure.However after the failure on the part of the insurance company to repay the government injected funds to protect the economy from collapsing.

Post 2008 financial crisis legal framework was developed for regulating swaps and increased ttansperancy in the market to regulate the swap in the market.The Dodd-Frank Wall Street Report Act of 2009 was introduced to regulate the credit default swap market. Further setting up clearinghouse for settlement of swap was also done.