Credit Default Swaps

[boont]

In researching the definition of credit default swaps I came up with this little beauty. This is partially from the British Bankers Association Credit Derivites Report by way of Wikipedia and a banking dictionary.

"Derivatives, such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder, for example, why the indices, like the DJIA, S&P500, etc., seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities, issued by such companies, may retain significant paper value, up until almost the very end. Instead of selling, investors can buy "insurance", in the form of derivatives, and keep holding their investments. This distorts the value of traditional market indices, because the decision to remove a failing company from the index, can be made well before the paper value drops to zero. This saves the value of the index. It creates the false impression that the index always rises. The underlying markets, for which the index was developed to reflect value, however, may be far more unstable than appearances indicate. False appearances of stability, in turn, allows securities markets to appear far less risky than they really are, encourage less knowledgeable players to speculate on derivatives, and allow broker/dealers, and some academics to claim that markets are far better investments, for the retail investor, than they really are. The overall affect is to reduce the perception of risk, itself. The risk still exists. The perception, however, reduces risk premiums, encouraging shoddy loan practices, and, in the end, may be the cause of runaway financial bubbles, when irrational exuberance gains traction, on the basis of inaccurate information."

I still haven't quite figured out how one can have a nominal value of bonds in the country and have a credit default swap value for those bonds that is tens times the value of the bonds themselves. But that will come in time.

b.