Credit default swaps have been introduced to the market by JP Morgan in 1997. As an alternative investment management product, credit default swaps have negative reputation, especially after the financial crisis in 2008. However, in 2012 the value of the CDS market has reached $29 trillion. In March 2012, there was a huge sovereign default in the international markets when creditworthiness of Greece decreased sharply. Holder’s of the CDS contracts got almost $2,6 billion in payouts.
Credit default swaps transfer the credit risk between two parties and is very similar to insurance by providing to the owner of the contract the protection against a default, a credit rating downgrade or another undesirable credit event. The buyer of the CDS will get protection or earn a profit if no negative credit event occurs. If undesirable credit event appears, the seller of the CDS will have to deliver the value of contract and interest payments that the reference bond would have paid. While, the buyer of credit default swap will have to deliver either cash or the actual bonds to the protection seller.
The other over-the-counter derivatives have one main difference from credit default swaps. Credit default swaps depend on the probability that a certain company will default during a particular period of time. While, the other over-the-counter derivatives appertain on equity rates, exchange rates, interest rates and etc. However, we cannot assume that any alternative investment management participant in the market has better information about these variables than any other market participant. Beyond question, some market participants have more information than others. If one financial institution is working with a particular company and makes loans, provides special advice or handles other issues it definitely will have more inside information about creditworthiness of the company than other market participants who are not dealing with this company. It is known as an asymmetric information problem.
