Credit Derivatives: Did They Exacerbate the 2007 Global Financial Crisis? AIG: Case Study

Abstract

Banks and other financial institutions have increasingly realized the necessity to measure and manage the credit risk of their loans. Credit derivatives CDs, therefore, have arisen in response to the surging demand of financial institutions to design vehicle tools for hedging and transferring credit risks. Credit Default Swaps CDS are valuable financial tools that have created system- wide benefits. However, at the same time these innovation contracts have likewise created the prospect for market participants to destabilize the whole economic system. Over the last years, international financial markets have suffered disastrous disruptions caused by various factors. The most important of these factors, in particular, is the detrimental impact of CDs as hedge funds on different markets of different sizes and structures. They have been blamed for part of the difficulties associated with the subprime credit crisis. As though, these credit risk transfer products require a basis for sound applications and uses. This study aims to elucidate on the problems associated with market participants in particular the large financial institutions that were eminently involved the recent financial crisis. Furthermore this paper presents a discussion of the blaming of hedge funds for financial crisis by focusing on the American International Group which blundering in the CDS market and causing system-wide instability, and argue the company's high efficient risk management and profuse diversity financial tools, which insure financial institutions, could prevent sorts of financial risks. As a result of AIG's exposure analysis in CDS positions, we find CDS were key contributor on igniting and exacerbation of current financial crisis.