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The Economics of Credit Default Swaps (CDS)

29 Pages Posted: 21 Jul 2010 Last revised: 21 Nov 2010

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: October 28, 2010

Abstract

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.

Keywords: CDS, Collateral, Defaults, Bonds, Insurance

Suggested Citation

Jarrow, Robert A., The Economics of Credit Default Swaps (CDS) (October 28, 2010). Johnson School Research Paper Series No. 31-2010. Available at SSRN: https://ssrn.com/abstract=1646373 or http://dx.doi.org/10.2139/ssrn.1646373

Robert A. Jarrow (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

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