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cds - Credit Default Swaps and the 2007-2009 Crisis Pierre...

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Credit Default Swaps and the 2007-2009 Crisis Pierre Garreau October 25, 2009 Introduction On August the 9 th 2007, the European Central Bank injects 94.8 Billion euros on the interbanking market to facilitate short term borrowing and insure liquidity. Two years later, the global production is dropping for the first time since the 2 nd world war, the unemployement rate in the United States has reached a 30 years’ high at 9.5%, the Dow Jones industrial has lost more than 50% of its value since October 2007 and the G-20 released a 1-trillion stimulus package to enray the branching e ff ects due to the collapse of the housing bubble and the ramifications of the Credit Crunch. Statistically striking, this crisis has even established itself at the center of political debates, raising the question of ethics and responsability, and become a sociological concern, relayed through media, by renewing the debate over living standards and cultural ideologies. In this salad bowl of misinformation, every node of the financial web has borne the blame - quantitative analysts, traders on derivative securi- ties, government o ffi cials, rating agencies, economists - and financial innovation has reached a peak of guilt familiar to 20 th century crisis. Admittedly, the current crisis is due to the convergence of a nation living o ff credit with a 2 years low interest rates policy and an abnormally lax oversight of fincancial authorities on the one hand, and government regulation on the other. Yet, it is undeniable that the exponential growth of the credit derivative market - attaining a market of 45 Trillion dollars for Credit Default Swaps (CDS) itself and 500 Trillion, i.e. 50 years of US wealth, for credit derivatives - has favored the creation of an unstable dynamic network of counterparts. The large scale unraveling of this network is at the heart of the liquidity crisis faced today and may be explained thanks to a thorough examination of the mechanism of CDS. After a brief overview of the di ff erent trends involved in the Credit Crisis in section 1, the focus in section 2 is geared toward the definition of credit risk and hedging solutions thanks to insurance
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Florida State University Department of Mathematics products: the CDS. We will see the assumptions underlying the construction of such products and the possible consequences of their transgression. Section 3 provides a mathematical framework to compute default probabilities based on fundamentals (capital structure), thus contrasting the common modelization of exponential time to default for CDS pricing. 1 The Credit crunch In mid October 1987, a sudden contagion gained the American markets following a significant drop of both Asian and European main indexes. Eventhough the litterature has extensively covered the episode, the fundamentals of the “Black Monday” crisis, explained by the mechanisms of dynamic portfolio insurance (DPI), are deeper than financial innovation itself. In fact, the rapid growth of
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