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Treating Uncertainty as Risk: The Credit Default Swap and the Paradox of Derivatives

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  • Christopher Brown
  • Cheng Hao

Abstract

The credit default swap (CDS) is implicated in the global financial crises because a vast market for securities collateralized by subprime mortgages and consumer debt could not have materialized if hedge funds and other holders of these instruments lacked a means of hedging default "risk." The argument is made that the CDS is an inherently defective concept because it is based on the assumption that future states of the economy are subject to probabilistic risk as opposed to uncertainty in the Keynes-Knight-Shackle-Davidson sense. The CDS also manifests the paradox of derivatives. By enabling individual money managers to safely increase leverage, it causes a system-wide buildup of leverage and financial fragility.

Suggested Citation

  • Christopher Brown & Cheng Hao, 2012. "Treating Uncertainty as Risk: The Credit Default Swap and the Paradox of Derivatives," Journal of Economic Issues, Taylor & Francis Journals, vol. 46(2), pages 303-312.
    • Handle: RePEc:mes:jeciss:v:46:y:2012:i:2:p:303-312
    DOI: 10.2753/JEI0021-3624460205
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    Cited by:

    1. Driouchi, Tarik & So, Raymond H.Y. & Trigeorgis, Lenos, 2020. "Investor ambiguity, systemic banking risk and economic activity: The case of too-big-to-fail," Journal of Corporate Finance, Elsevier, vol. 62(C).
    2. Annette Hofmann & Nicos A. Scordis, 2018. "Challenges in Applying Risk Management Concepts in Practice: A Perspective," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 21(2), pages 309-333, September.

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