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Credit Default Swaps Exploratory Essay


Introduction

Credit Default Swaps (CDS) are financial contracts that are similar to insurance policies where the insured parties are required to pay fees to the insurer, and in case of a credit event, the insured is subjected to compensation by the insurer. Some of the credit events where the insured parties are viable for compensation include bankruptcy and defaulting payment.

However, the CDS is different from the typical insurance policies. Unlike in the typical insurance policy, the insured parties in CDS do not need to hold any financial burdens on their side. A case example of the CDS use is where an individual insures another person’s car. In such a situation, if that car is involved in an accident, the individual will be compensated even though he does not own the car.

The Credit default swaps were initiated in the 1990s for the purpose of preventing the risk associated with credit. It was widely adopted in the mid 90s by financial institutions to cater for the risks associated with commercial loans. Commercial banks and other financial institutions used CDS as a cautious measure for the risks associated with offering huge corporate loans.

CDS was preferred because it allows the lender and the debtor to avoid all the formalities and procedures related to the insurance policies. The regulations of the formal insurance policies required that financial institutions compulsorily hold a reserved amount similar to the amount that is lent out.

Therefore, the CDS was easily adopted by most financial institutions because it was a way of transferring the credit associated risks to someone else, thus allowing them to lend more capital (Tett, 2009).

In 1997, one of the earliest users of CDS policy J.P. Morgan consolidated 300 different loans valued at $9.7 billion that had been forwarded to various financial organizations. These loans were then subdivided into small portions and offered to investors such as Broad Index Securitized Trust Offering.

In the late 90s, CDS contracting had been adopted by large corporate and council bonds. Within a span 2 years, the CDS market worth was above $900 billion. However, the early adopters of the CDS structure were fewer; therefore, caution was closely taken to enhance the understanding of the terms and conditions of the agreement.

CDS use was adopted by more countries such as Australia, Switzerland, Canada and Hong Kong. The lending and deposit rates of most countries are however dominated by dollar ratings. The difference between the dollar and the local currencies determines the CDS rates and can even result to losses.

As the CDS contracts were adopted by the corporate and sovereign sectors, municipalities and other financial institutions. These financial institutions mostly use CDS contracts for cases where mortgages and other collaterals are used as loan securities.

Unlike the insurance lending policy, the CDS sellers were not subject to formalities such as holding reserves against CDS in case of credit default. With the improvement of CDS, the financial institutions were allowed to sell insurance collateralised by assets such as residential mortgages (Barry, 2009).

The CDS requires the insured party to pay a fee that is calculated based on the amount insured under specified periods of time. The payment of the premiums is continuous until the expiry of the contract. The compensation may be done in either physical or cash form. In a situation where compensation is being offered in physical form, the insured party present the insured bond to the insurer that in return pays the face value of the loan.

However in case of payment in cash form, the insurer compensates the variation in value between the parity value and the value of the property at that time. Additionally, the owners of the CDS contracts must not be the original owners since they can be transferred to other partied as long as the CDS contract is not expired.

Overview

Prime risk is what investors face while investing in loan or debt instruments known as credit risk, which also refers to the risk of default from borrowers (Backshall, 2004). Usage of credit default swaps as a risk management tool has increased in recent times, since many financial institutions in markets around the world have accepted the use of credit default swaps to better hedge their risk (Malhotra, 1993).

Due to the collapse of some major organizations such as WorldCom, Enron, Marconi and other major institutions, concerns have been raised from investors regarding credit risk (Barry, 2009).

Therefore, in order to hedge against credit risk financial institutions are seeking help from credit derivatives where investors insure their investments from any adverse movement which would have otherwise lead to lower credit quality (Bomfim, 2001).

The aim of present research is to explore impacts of credit default swaps on UK as well as on US markets in terms of their financial instability and impacts on market driving forces such as interest rate (Chen et al, 2004).

Current research would make out specific financial implications of credit default swaps into selected markets where the major focus of the research would be to develop a direct relationship between market driving forces and the growth of credit default swaps in UK and US (Neal, 1996).

Research problem

The research problem in context relates to the investigation of limitations and advantages of the credit default swap phenomenon on UK and US markets (Rule, 2001). For a positive impact focus would be on finding out the role of CDS as a catalyst to enhance market efficiency and credit growth (Kinnear & Taylor, 1991).

A negative impact of CDS would shift the focus of the research to exploring fluctuations in interest rates as a defect due to CDS and expound on the impact on the overall financial instability in UK and US (Edward, 2004). The relevancy of present research can be established in lieu of developing proper CDS processes and analyzing impacts of CDS on financial instability of market and its driving forces (Kothari, 2002).

After a short period of time, Financiers started using CDS to engage in risky investment markets that entailed the insuring the debts belonging to the developing nations.

Towards the end of 2007, the CDS market was worth more than $45 trillion while the corporate and municipal council bonds were not more than $25 trillion. This fact implied that more than $20 trillion comprised of promises by parties that were not viable for the credit.

The housing sector suffered in 2007 because most of the home owners who had taken loans were not able to repay their mortgages. The 2007 financial crisis brought about irregularities such as lack of transparency in the CDS market, therefore, posing a systemic risk which could cause a collapse in the entire CDS market resulting to financial instability.

This cause large numbers of home owners to default loans and the lenders repossessed the land and houses which later became worthless as compared to the lent out amount. This factor made offering and receiving loans difficult. However, the financial crisis played a major role in enhancing better regulations to prevent illegal lending (Barry, 2009).

Research objectives

Objectives for the current research can be given as below:

  • To determine the role of credit default swaps in enhancing financial market efficiency
  • To determine the relationship between credit default swaps and rate of interest?
  • To determine the relationship between credit default swaps and credit growth in UK and US?
  • To determine the role of credit default swaps in global financial crisis.

Literature summary

There have been many contributions to the literature of understanding impacts of credit default swaps on developed countries such as UK, US and Russia (Stasch, 1989).A study with similar research concern was carried out by Anees, 2006, which was aimed at finding out the financial impact of the credit default swap derivatives (Brandon and Fernandez, 2004).

The prime difference in the study undertaken and our research context is that his research was moreover focused on analyzing impacts of CDS on macroeconomic (Tomasz and Rutkowski, 2002) entities and studying impacts on several developed and developing countries along with their financial institutions involved in the CDS (Tett, 2009).

Another attempt in the field was made by White et al, 2002 and the study was aimed at exploring relationship which CDS has with bond yield and credit rating announcements in developed economies (Narayan, 1998).

Further this study was moreover concentrated on the financial data analysis in order to establish relationship between derivative markets and developing methodology which shows how CDS cascaded with other economic downturn phenomenon, which weakens the overall economy (Cassel and Symon, 1994).

Therefore, focus in this current research was to study the negative side of CDS while our research would be differentiated from this research as our primary aim of the research would be to look at both negative as well as positive impacts of CDS on UK and US economies (Blanco, 2005).

Another research effort in the context was made by Rene, 2005 where the prime focus of the research was to understand the role in which CDS have played in the credit crisis for several countries (Chan-Lau, 2003). Further research highlighted negative impacts of CDS on sub-prime mortgage which lead to financial crisis in several developed and undeveloped economies around the world (Schiffman and Kanuk, 2004).

Research also tried to analyse the overall credit default swap (Tull and Hawkins, 1987) market and its potential benefits & limitations for companies holding large portfolios of such derivatives (Clark, 2002).

This research was unique in itself as higher emphasis was given to the phenomenon of CDS being responsible for the sub-prime crisis and analysis was done in order to find out what economic destruction resulted from it.(Dimities, 2000)

.The present research would be different from the above research contexts as the major focus here would be to look into both negative as well as positive impacts of CDS (Zickmund, 2002) specifically in UK and US (Creswell, 1994).

Further the macroeconomic phenomenon such as interest rate and credit growth would have a higher level of focus where the research would analyze impacts of CDS on interest rate fluctuations in an economy (Mark et al, 2000).

Methodology

The present research context would be exploratory as well as experimental in nature where both qualitative as well as quantitative research frameworks would be taken into consideration (Denzin and Lincoln, 2000). Research would be exploratory as it would try to gauge the negatives as well as positive impacts of the CDS process on developed economies such as UK and US (Minton, Stulz, & Williamson, 2009).

Further experimental research context can be established as macroeconomic variables such as interest rate and credit growth would be analyzed against the role of CDS in the economy (Lee et al, 1999).

Usage of qualitative information would be to obtain observational information and secondary information while quantitative information would provide the relationship among several variables through statistical analysis (Kiff and Morrow, 2000).

Data collection

Research would engage both primary as well as secondary collection methodologies in order to collect the data.The purpose of the primary data would be to analyze role of CDS on the instability of financial markets in developed countries like UK and US (Diamond, 1987).

Also,the primary data collection process would help in understanding the role which CDS play in order to impart a higher level of market efficiency (Stewart and Kamins, 1993).

For the purpose of primary data collection, semi-structured interviews can be conducted which would help to understand phenomenon and would also offer a high degree of flexibility (Hull, 2003). Role of secondary data collection would be to analyse the impact of CDS on interest rate and credit growth in developed economies (Stiglitz, 2002).

Data analytical tool and potential results

The data analysis process includes the modeling of information attained through several resources and extracting information in such a way that collected data make sense in response to the objectives of the research (Kristianslund et al, 1995).

As the current research involves both primary as well as secondary data so in order to analyze both kinds of data dual data analysis techniques would be used (Harrington and Niehaus, 2004). For analysis of primary data collection through interview, content analysis tool would be used where semi-structured interviews would be conducted through designed questionnaires for the interview process (Laurie, 2008).

Interview questionnaires would be designed in such a way to outline the research objectives regarding which data collection needs to be done (Harper, 1989). Here the major focus would be towards observational data and extracting desired data through interpretation of interview (Ghauri and Gronhaug, 2002).

In order to analyze quantitative data obtained through journals, research papers, and other statistical data, present statistical tools such as excel would be used where cross tabs, charts and graphs would be developed to represent data collected (Fabozzi, 2000). Quantitative data analysis would be used to establish relationship between interest rates and CDS in developed economies such as US and UK (Strausse and Corbin, 1998).

Statistical data collected through several financial institutions and journals would provide direct proof for those economies whom showed growth from credit default swaps especially on credit growth and interest rates (Carl, 1999).

Potential results which are expected from the current research include financial instability lead by credit default swaps in case there are over exposure taken by financial institutions for the credit default swap which not only endangers the particular organization, but also impacts other market players as well (Duffie and Singleton, 2003).

Interest rate fluctuations have major impacts on credit default swaps as there would be a lower value of investment made especially for bonds, but no insurance can be attained in such situations (Dickinson, 2001).

Credit default swaps would prove an efficient tool in order to enhance market efficiency until the time there are proper monitors in place for the credit given by financial institutions and there are adequate amount of CDS portfolios held by particular organizations (Tavakoli, 1998).

References

Barry, E 2009, How the subprime crisis went global: evidence from bank credit default swap spreads, National Bureau of Economic Research Cambridge, Mass.

Blanco, R 2005, ‘An Empirical Analysis of the Dynamic Relation between Investment-grade Bonds and Credit Default Swaps’, Journal of Finance , vol. 60, no. 5, pp. 2255–2281.

Carl, M 1999, Contemporary marketing research, South-Western College Pub Cincinnati.

Diamond, D 1987, ‘Constraints on Short-selling and Asset Price Adjustment to Private Information’, Journal of Financial Economics, vol. 18, pp. 277–312.

Dimitris, C 2000, Credit derivatives and the management of risk, New York Institute of Finance, New York.

Edward, R 2004, Swaps & other derivatives in 2004, Practising Law Institute, New York, NY.

Harper, B 1989, Marketing research: text and cases, Irwin, Homewood, Ill.

Laurie, G 2008, Subprime mortgage credit derivatives,: John Wiley & Sons, Hoboken.

Minton, BA, Stulz, R & Williamson, R 2009, ‘How Much Do Banks Use Credit Derivatives to Hedge Loans?’, Journal of Financial Services Research, vol. 35, no. 1, pp. 1–31.

René, S 2009, Credit default swaps and the credit crisis, National Bureau of Economic Research, Cambridge, Mass.

Tett, G 2009, Fool’s Gold, Free Press, New York.

Yavorsky, A 2009, Analyzing the Potential Impact of Credit Default Swaps in Workout Situations, Moody’s Investors Services, New York.

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"Credit Default Swaps." IvyPanda, 1 July 2019, ivypanda.com/essays/credit-default-swaps/.

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IvyPanda. "Credit Default Swaps." July 1, 2019. https://ivypanda.com/essays/credit-default-swaps/.

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IvyPanda. 2019. "Credit Default Swaps." July 1, 2019. https://ivypanda.com/essays/credit-default-swaps/.

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IvyPanda. (2019) 'Credit Default Swaps'. 1 July.

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