Credit default swaps : tools for risk management or speculation?

Abstract

Up until the recent sub-prime crisis, 'credit default swaps' was a term that not many had ever heard of but in the past couple of years there has been much talk about them as many are those who believe that they contributed significantly to this financial crisis whilst others oppose this idea. These credit derivatives have become quite controversial as just over a decade ago they were freed from regulation and some commentators see them as incentivising moral hazard and speculating by betting in favour of a company/country's failure. There are also analysts who argue that credit default swaps have actually made the sovereign crisis worse as investors wanted to gain from the collapse of a country's financial collapse. What originally was aimed to be a risk management tool is being viewed as a destructive speculative tool due to its high systemic risk. This study begins by analyzing the credit default swap market, its development and the mechanics of this financial instrument. The scope of this dissertation is to examine the credit default swap's role as a hedging tool as well as a tool for speculation, evaluating all of its potential risks and seeing its effects on the latest financial crises. Case studies were also conducted on a renowned insurance company, AIG, and on an individual, John Paulson, who during the credit crunch were both drastically affected by the credit default swaps, albeit differently. The report also includes a solution by means of a central counterparty and new regulation to reduce the risks in this market and to make it more robust to withstand potential shocks.