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The Economics of Credit Default Swaps

Author

Listed:
  • Robert A. Jarrow

    (Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853 and Kamakura Corporation, Honolulu, Hawaii 96815)

Abstract

Credit default swaps (CDSs) are term insurance contracts written on traded bonds. This review studies the economics of CDSs using the economics of insurance literature as a basis for analysis. It is alleged that trading in CDSs caused the 2007 credit crisis, and therefore trading CDSs is an evil that needs to be eliminated or controlled. In contrast, I argue that the trading of CDSs is welfare increasing because it facilitates a more optimal allocation of risks in the economy. To perform this function, however, the risk of the CDS seller's failure needs to be minimized. In this regard, government regulation imposing stricter collateral requirements and higher equity capital for CDS traders needs to be introduced.

Suggested Citation

  • Robert A. Jarrow, 2011. "The Economics of Credit Default Swaps," Annual Review of Financial Economics, Annual Reviews, vol. 3(1), pages 235-257, December.
    • Handle: RePEc:anr:refeco:v:3:y:2011:p:235-257
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    Citations

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    Cited by:

    1. Yixin Chen & Junrui Zhang, 2019. "The Interdependence of Debt and Innovation Sustainability: Evidence from the Onset of Credit Default Swaps," Sustainability, MDPI, vol. 11(10), pages 1-24, May.
    2. Ausloos, Marcel & Castellano, Rosella & Cerqueti, Roy, 2016. "Regularities and discrepancies of credit default swaps: a data science approach through Benford's law," Chaos, Solitons & Fractals, Elsevier, vol. 90(C), pages 8-17.
    3. Arakelyan, Armen & Rubio, Gonzalo & Serrano, Pedro, 2015. "The reward for trading illiquid maturities in credit default swap markets," International Review of Economics & Finance, Elsevier, vol. 39(C), pages 376-389.
    4. Dionne, Georges & Gauthier, Geneviève & Hammami, Khemais & Maurice, Mathieu & Simonato, Jean-Guy, 2011. "A reduced form model of default spreads with Markov-switching macroeconomic factors," Journal of Banking & Finance, Elsevier, vol. 35(8), pages 1984-2000, August.
    5. Shalendra D. Sharma, 2013. "Credit Default Swaps: Risk Hedge or Financial Weapon of Mass Destruction?," Economic Affairs, Wiley Blackwell, vol. 33(3), pages 303-311, October.
    6. Christina E. Bannier & Thomas Heidorn & Heinz-Dieter Vogel, 2014. "Characteristics and development of corporate and sovereign CDS," Journal of Risk Finance, Emerald Group Publishing, vol. 15(5), pages 482-509, November.
    7. Oehmke, Martin & Zawadowski, Adam, 2015. "Synthetic or real? The equilibrium effects of credit default swaps on bond markets," LSE Research Online Documents on Economics 84511, London School of Economics and Political Science, LSE Library.
    8. Shanuka Senarath & Pelma Rajapakse & Jan Job de Vries Robbé & Naveen Wickremeratne & Maduka Subasinghage, 2022. "Being Naked - et Quo hinc ?: Developing a ‘Skin-in-the-Game’ Solution for Credit Default Swaps," IJFS, MDPI, vol. 10(4), pages 1-14, October.
    9. Carruthers, Bruce G., 2013. "Diverging derivatives: Law, governance and modern financial markets," Journal of Comparative Economics, Elsevier, vol. 41(2), pages 386-400.
    10. Wei Jiang & Jitao Ou & Zhongyan Zhu, 2021. "Mutual Fund Holdings of Credit Default Swaps: Liquidity, Yield, and Risk," Journal of Finance, American Finance Association, vol. 76(2), pages 537-586, April.
    11. Jie Chen & Woon Sau Leung & Wei Song & Davide Avino, 2018. "Does CDS trading affect risk-taking incentives in managerial compensation?," Working Papers 2018-19, Swansea University, School of Management.
    12. Lannoo, Karel & Thomadakis, Apostolos, 2020. "Derivatives in Sustainable Finance," ECMI Papers 29791, Centre for European Policy Studies.
    13. Hertrich, Markus, 2015. "Does Credit Risk Impact Liquidity Risk? Evidence from Credit Default Swap Markets," MPRA Paper 67837, University Library of Munich, Germany.
    14. Augustin, Patrick & Subrahmanyam, Marti G. & Tang, Dragon Yongjun & Wang, Sarah Qian, 2014. "Credit Default Swaps: A Survey," Foundations and Trends(R) in Finance, now publishers, vol. 9(1-2), pages 1-196, December.
    15. Bolton, Patrick & Oehmke, Martin, 2013. "Strategic conduct in credit derivative markets," International Journal of Industrial Organization, Elsevier, vol. 31(5), pages 652-658.
    16. Jessie Jiaxu Wang & Agostino Capponi & Hongzhong Zhang, 2022. "A Theory of Collateral Requirements for Central Counterparties," Management Science, INFORMS, vol. 68(9), pages 6993-7017, September.
    17. Paul Mizen & Veronica Veleanu, 2015. "On the Information Flow from Credit Derivatives to the Macroeconomy," Discussion Papers 2015/21, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).
    18. Yu-Lin Wang & Chien-Hui Lee & Po-Sheng Ko, 2020. "Do Loan Guarantees Alleviate Credit Rationing and Improve Economic Welfare?," Sustainability, MDPI, vol. 12(9), pages 1-16, May.

    More about this item

    Keywords

    CDS; collateral; defaults; bonds; insurance;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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