It is essential to recognize that credit default swaps refer to the standard credit derivatives that are used in the protection of the buyers of the instruments against risks of defaults (Wallison, 2008). It also protects the buyer from any of the events connected to the credit issues especially the issues that are particularly specified deliberately in the contract (Wallison, 2008). It is this instrument that allows the change in the risk default of the underlying credit from the purchaser to the seller that ensures the protection of the credit (Wallison, 2008). The credit default swaps are used in the process of measuring the actual credit conditions of the business organization specifically during the moment of financial difficulties. Therefore, in real practice, it is similar to the buying of insurance against any possibility of default (Wallison, 2008). For instance, a buyer delivers a specific asset to the seller and then receives a 100% of the notional value specified in the credit default swaps
Therefore, in this paper takes the example of Lehman Brothers where credit default swaps were categorically instrumental in the measurement of the company’s debt (Wallison, 2008). The credit default swaps allowed the Lehman Brothers to recognize that the business’s debt was not worth anything. The credit default swaps provided the opportunity for the Lehman Brothers to establish the fundamental creditworthiness of their company (Wallison, 2008). Most of the investors and analysts around the world use the stock price as an important indicator to describe and fully understand the future of the business organization. It is used in the popular technical analysis of the business situation
However, it is also essential to appreciate that the most problematic aspect of this technical analysis is that it is not easy to master and even comprehend whether there is the likelihood of a deviation in the results (Wallison, 2008). It is mostly reliant on the company’s previous performances which are not sometimes sufficient and accurate in the prediction of the business future. It is hence essential to know that the credit default swaps specifically when used for technical analysis provides biased and also less reliable (Figlewski & Smith, 2008). The next place where the credit default swaps are used is the credit rating. The credit rating is essential in helping the business organization to know its creditworthiness in the market. However, it is also characterized by numerous disadvantages (Figlewski & Smith, 2008). For instance, in the event where a company fails to disclose all the necessary information then the credit rating will automatically not yield any positive results (Figlewski & Smith, 2008). The accuracy and reliability of the credit rating are dependent on the ability of the company to disclose all relevant and vital information. It is a static study because it doesn’t show the soundness of the statement as well as the company rating. The credit rating approach can be biased especially if other confusing rating criteria influence the credit agency
The other market indicators were not reliable and appropriate in the Lehman Brothers financial crisis (Figlewski & Smith, 2008). The credit default swaps reactions were evident well before the release of public information. The credit default swaps provide a significant response against the negative information when compared to the positive report (Figlewski & Smith, 2008). However, the CDS have more advantages when compared to other market indicators when it gets used in the analysis of creditworthiness. It is crucial in the provision of vital information about the company’s financial challenges (Figlewski & Smith, 2008). The credit default swaps provide a significant indication about the financial risks involved in any investment decisions (Figlewski & Smith, 2008). Therefore, it is vital to realize that credit default swaps provide comprehensive information about current market situations which is not viable in other sources used in the risks analysis.
Figlewski, S., & Smith, R. C. (2008). Credit Default Swaps Are Good For You – Forbes. Retrieved on April 6, 2019, from http://www.forbes.com/2008/10/20/buffett-lehman-derivatives-oped-cx_sf_rcs_1020figlewskismith.html
Wallison, P. J. (2008). Everything You Wanted to Know about Credit Default Swaps–but Were Never Told – Economics – AEI. Retrieved on April 6, 2019, from http://www.aei.org/outlook/economics/financial-services/everything-you-wanted-to-know-about-credit-default-swaps–but-were-never-told/