Credit derivatives swaps (CDS) are the main pillars in the credit derivatives market and represent about half of its volume (George Spentzos, 2005). A CDS is a bilateral contract between a protection buyer and a protection seller that exchanges the credit risk of a specific issuer. The protection buyer pays a premium to the protection seller to assume the risk associated with a particular credit event.

Credit default swaps are traded in over the counter markets, and indices exist which are averages of CDS contracts on various firms. CDS are priced such that the price reflects the likelihood of default and losses associated with default, and because they are not directly related to funding, this market became more liquid than the market of the securities that are insured by using CDS contracts. Further, CDS can be bought and traded by investors on assets that they do not own.

In their true sense, CDS should contribute to make the financial system efficient by separating the credit risk and cost of investing and thus shifting the credit risk to those willing to take it. This should not only reduce firms’ cost of capital, but also facilitate investors at large to gauge a company’s credit risk (rather than the market where firms’ securities are traded) (Stulz 2010, p. 75).

But it is also believed that CDS lower the incentives of lender to monitor their borrowers because they can hedge against the risk of default by borrowers. Although the counter argument holds that because banks can reduce their risk by entering into CDS contracts, hence firms in the economy would now receive larger amount of credit that otherwise possible. However, in 2005 only U.S. banks had utilized credit default swaps to insure only 2 percent of their credit exposure on average (Stulz 2010, p. 76). Further, these CDS contracts can also substantially change investor psyche by reversing the dynamics of investment for him. E.g. if an investor is approached to suggest a restructuring of debt of a company he has invested in, now if he has insured his debt by CDS and he can make a gain under bankruptcy of the company, his verdict may be affected than what he would decide otherwise (Yavorsky 2009). Thus, CDS directly or indirectly affects the psyche of financial intuitions’, be it institutional investors or lending houses.

Turning to what is claimed as the most sounding reason of financial crisis: the subprime mortgages, we need to know how the use of credit derivatives influenced the market dynamics. Subprime mortgages are securitized i.e. securities are issued against a pool of mortgages in the form of trenches, reflecting their seniority in payments. When mortgages default, the lowest rated trench suffers from the default loss the most with the loss stepping upwards to highest rated trench. ABX indices on subprime securitizations were introduced in 2006 based on average of credit default swap for a particular seniority tranche. Fall in the value of these indices would mean a fall in the value of subprime securities, and thi