The credit default swap (CDS) market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. Today, CDS have become
the engine that drives the credit derivatives market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customize exposure to corporate credit. Today the CDS market represents more than $10 trillion in gross notional exposure.
(i) Distinguish between a credit default obligation and a credit default swap.
(ii) Describe the roles of each of the participants to a CDS.
(iii) Draw a diagram showing the cash flows that arise under the CDS.
(iv) With reference to the global financial crisis, outline the residual risks that would remain
(including additional risks that would arise) if a CDS were to be used.