Can anyone explain me what is a Credit Default Swap? And what are the merits and demerits of it?
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It’s a bet. If I sell you a CDS I am taking your money because I like money. I promise you that is some specific loan defaults (the borrower doesn’t make the payments), I will pay you back. I’m betting they won’t default.
Like all bets, it’s relatively fair and useful if defaults are random. The lender is sharing the risk with CDS sellers, and like all insurance the CDS sellers get to make a little profit for this risk reduction.
The 2008 Economic Collapse was caused by CDS use. It turns out that home loan defaults are not random. An economic downturn can cause a spike in them because everybody needs the economy to do well to keep their job so they can pay their mortgage.
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