A credit default swap is an instrument designed to transfer the credit exposure of fixed income products between parties.
Credit default swaps are a type of credit insurance in which one party (a bank, investment bank, or hedge fund) pays another party to protect it from the risk of default on a debt instrument, such as a bond, a bank loan, or mortgage.
If the debt instrument defaults, the insurer (such as the bank or hedge fund) compensates the insured for his loss.
Credit default swaps (CDS) were largely unknown until the ballooning CDS market eventually brought global financial markets unstuck, resulting in the global financial meltdown of 2008. Credit default swaps enabled banks to issue complex debt securities by reducing the risk to buyers.
Before the financial crisis, the institutions that offered credit default swaps saw it as an easy way to generate income from the premiums and fees paid by the buyers.
At the start, credit default swaps were seen as relatively low risk investments by the banks and insurance companies. However, these instruments expanded into the mortgage loans market and were adopted by hedge funds to insure against various financial risks.
The CDS market grew exponentially from around 2003, and by the finale of 2007 boasted over USD 62 trillion, according to the International Swaps and Derivatives Association (ISDA). AIG and Swiss Re dominated the market.
Both companies hit trouble when calls were made on the credit default swaps they’d sold to countless companies, funds, and other entities. AIG was eventually bailed out by the US government after enormous write downs as much as 11 trillion US dollars.
By the end of 2008, the CDS market had plummeted by almost 30 percent, to 38.6 trillion US dollars, according to ISDA.
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