The Economics of Credit Default Swaps (CDS)
Robert A. Jarrow
Cornell University - Samuel Curtis Johnson Graduate School of Management
October 28, 2010
Johnson School Research Paper Series No. 31-2010
Credit default swaps (CDS) are term insurance contracts written on traded bonds. This paper studies the economics of CDS using the economics of insurance literature as a basis for analysis. It is alleged that trading in CDS caused the 2007 credit crisis, and therefore trading CDS is an "evil" which needs to be eliminated or controlled. In contrast, we argue that the trading of CDS is welfare increasing because it facilitates a more optimal allocation of risks in the economy. To perform this function, however, the risk of CDS seller failure needs to be minimized. In this regard, government regulation imposing stricter collateral requirements and higher equity capital for CDS traders need to be imposed.
Number of Pages in PDF File: 29
Keywords: CDS, Collateral, Defaults, Bonds, Insurance
Date posted: July 21, 2010 ; Last revised: November 21, 2010
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