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Credit Default Swaps

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It is the objective of this research to determine the causes of the financial market collapse of 2008 and recommend directions towards a lasting solution, or prevention of the same from happening again. To come to this generalization, the paper shall attempt the following:

Early in the 1990s, innovative inroads into credit risk management found their way into the development of the credit derivative. The credit derivative is a financial instrument designed to separate market risk from credit risk. Its purpose has been described as “the transfer of credit exposure of an underlying asset or assets between two parties” (Anson et al, 2004, p. 23). It is thus a tool to manage or distribute the risk associated with the lending of funds, in order to protect the lender from credit risk.
Downgrade Risk. Downgrade risk refers to the risk that a reputable and recognized credit ratings agency reduces it credit rating for an issuer. The most relied-on ratings are those released by Moody’s Investors Services, Standard &amp. Poor’s, or Fitch Ratings. These ratings are based on the agency’s evaluation of the debt issuer’s current earning power vis-à-vis its capacity to pay its debt obligations as they become due.

Credit Spread Risk. Credit spread risk is the risk that the spread (or premium) over a reference rate will increase for an outstanding debt obligation. In contrast, to downgrade risk, which is published by a particular rating agency, credit spread risk is the financial markets’ reaction to perceived credit deterioration (Anson et al 2004, p. 23).
Operational risk refers to the possibility of a breakdown in the operations of the derivatives program or risk management system. This is envisioned in the occurrence of events such as power failures, crashed computer systems, and virus problems, or human error in the&nbsp.recording and monitoring of records.&nbsp.&nbsp.