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Credit Default Swaps: Risk Hedge or Financial Weapon of Mass Destruction?

Authors

  • Shalendra D. Sharma

    Professor
    1. Department of Politics, University of San Francisco
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    • The author would like to thank two anonymous referees and the editor for their insightful comments, which have helped to improve this paper. He is responsible for all remaining errors.

Abstract

Credit default swaps (CDSs) are contracts between buyers and sellers of protection against default. They are a form of debt insurance, or more precisely derivatives contracts that investors buy to either insure against or profit from a default. In this way CDS contracts act as a form of debt insurance in that they provide a means of protection against credit risk. In the aftermath of the global financial crisis, the CDS earned the reputation of a ‘financial weapon of mass destruction’. Why? Is this charge justified? This paper shows that the reality is more complex: CDSs carry benefit as well as costs, and the risks associated with them can be mitigated through prudent supervision.

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