What Is a Credit Default Swap Market?

Osmand Vitez
Osmand Vitez
Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

Financial markets represent places where individuals and businesses can come together and buy or sell securities. A credit default swap market is a relatively new financial market that primarily deals in the exchange of derivatives that involve related securities. The attraction of a credit default swap is the ability to make high financial returns even though risk is prevalent, which may be from small to large amounts for these investments. The purpose of the credit default swap market is to reduce the risk from several individual securities by packaging them together in a single investment. These markets can be both domestic and international for the derivatives sold among parties.

Individuals and large businesses can be parties to transactions that involve the use of a credit default swap market. One of the most popular types of credit default swaps is the combination of several mortgages into one single financial derivative. This investment requires a specific market where the seller of these derivatives can price the investment partly based on market risk. Additionally, specific regulations may exist that force a financial services firm to follow rules that relate to these investments. Financial services firms are typically the major sellers of the credit default swaps, though buyers can be just about any investor.

A credit default swap market can be highly profitable in an economy that has several different types of financial markets. Due to this market being fairly new in the past several years, advanced economies may be the only ones where credit default markets exist. Therefore, few markets exist where an individual can actually purchase these investment types, though the volume of credit default swaps sold may not reflect the lack of a market. Each market may also have the ability to create a credit default swap that has certain specifics. For example, a financial services firm may create swaps that are low, medium, and high risk to ensure different package types are available to suit the needs of investors.

Credit default swaps have become a highly controversial part of the financial services industry. Many of the default swaps that included subprime mortgages turned out to be worthless. The credit default swap market has become a target for severe financial regulation in order to reign in the problems associated with these investments. Financial institutions selling these investments are typically under fire for regulatory purposes, including the institutions that create the credit default swap. This may be a reason for a country to create a specific market for these types of investments.

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