Question

true/false？

1. A CDS could be dangerous especially since it may incentivize risky investments, like emerging markets bonds or subprime loaded MBS, and transfer risk outside of financial institutions to insurance industry as a form of insurance.

2. Credit default swaps contributed to the financial crisis of 2007-2009 by making it easier for sellers of insurance to assume and conceal risk.

Swap regulation was a component of Dodd Frank post 2008, this means that
3. If swaps, like CDS, become very regulated this will prevent the financial institutions from keeping risky investment products off their books.

Answer 1

Statement 1 is true because CDS is very risky instrument it wont hedge risk it generally pass the risk the risk from one entity to another entity in the form of swap. Eventually the insurance companies bear the risk of the CDS in case of any default due to credit issue. Until debtors are good to keep its promise there is no issue but once debtor not able to pay the debt then insurancer of CDS has to pay the amount in case of default.

Statement 2 is true because there was no regulation regarding the CDS sells, seller were assuming huge risk and which lead to the 2007 09 crisis.

Statement 3 is also correct because Dodd Frank Act make sure the CDS market is under regulation and there should have clearing house so that risk in this instrument can be minimized.