✎✎✎ Naked Economics Chapter 8 Summary

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Naked Economics Chapter 8 Summary



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Naked Economics Chapter 1

As the price of a commodity falls, consumers move toward it from relatively more expensive goods the substitution effect. In addition, purchasing power from the price decline increases ability to buy the income effect. Other factors can change demand; for example an increase in income will shift the demand curve for a normal good outward relative to the origin, as in the figure. All determinants are predominantly taken as constant factors of demand and supply. Supply is the relation between the price of a good and the quantity available for sale at that price.

It may be represented as a table or graph relating price and quantity supplied. Producers, for example business firms, are hypothesized to be profit maximizers , meaning that they attempt to produce and supply the amount of goods that will bring them the highest profit. Supply is typically represented as a function relating price and quantity, if other factors are unchanged. That is, the higher the price at which the good can be sold, the more of it producers will supply, as in the figure. The higher price makes it profitable to increase production. Just as on the demand side, the position of the supply can shift, say from a change in the price of a productive input or a technical improvement. The "Law of Supply" states that, in general, a rise in price leads to an expansion in supply and a fall in price leads to a contraction in supply.

Here as well, the determinants of supply, such as price of substitutes, cost of production, technology applied and various factors inputs of production are all taken to be constant for a specific time period of evaluation of supply. Market equilibrium occurs where quantity supplied equals quantity demanded, the intersection of the supply and demand curves in the figure above. At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This is posited to bid the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded.

This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. Similarly, demand-and-supply theory predicts a new price-quantity combination from a shift in demand as to the figure , or in supply. People frequently do not trade directly on markets. Instead, on the supply side, they may work in and produce through firms. The most obvious kinds of firms are corporations , partnerships and trusts. According to Ronald Coase , people begin to organize their production in firms when the costs of doing business becomes lower than doing it on the market.

In perfectly competitive markets studied in the theory of supply and demand, there are many producers, none of which significantly influence price. Industrial organization generalizes from that special case to study the strategic behaviour of firms that do have significant control of price. It considers the structure of such markets and their interactions. Common market structures studied besides perfect competition include monopolistic competition, various forms of oligopoly, and monopoly.

Managerial economics applies microeconomic analysis to specific decisions in business firms or other management units. It draws heavily from quantitative methods such as operations research and programming and from statistical methods such as regression analysis in the absence of certainty and perfect knowledge. A unifying theme is the attempt to optimize business decisions, including unit-cost minimization and profit maximization, given the firm's objectives and constraints imposed by technology and market conditions. Uncertainty in economics is an unknown prospect of gain or loss, whether quantifiable as risk or not. Without it, household behaviour would be unaffected by uncertain employment and income prospects, financial and capital markets would reduce to exchange of a single instrument in each market period, and there would be no communications industry.

Game theory is a branch of applied mathematics that considers strategic interactions between agents, one kind of uncertainty. It provides a mathematical foundation of industrial organization , discussed above, to model different types of firm behaviour, for example in a solipsistic industry few sellers , but equally applicable to wage negotiations, bargaining , contract design , and any situation where individual agents are few enough to have perceptible effects on each other. In behavioural economics , it has been used to model the strategies agents choose when interacting with others whose interests are at least partially adverse to their own.

In this, it generalizes maximization approaches developed to analyse market actors such as in the supply and demand model and allows for incomplete information of actors. It has significant applications seemingly outside of economics in such diverse subjects as formulation of nuclear strategies , ethics , political science , and evolutionary biology. Risk aversion may stimulate activity that in well-functioning markets smooths out risk and communicates information about risk, as in markets for insurance , commodity futures contracts , and financial instruments. Financial economics or simply finance describes the allocation of financial resources.

It also analyses the pricing of financial instruments, the financial structure of companies, the efficiency and fragility of financial markets , [] financial crises , and related government policy or regulation. Some market organizations may give rise to inefficiencies associated with uncertainty. Based on George Akerlof 's " Market for Lemons " article, the paradigm example is of a dodgy second-hand car market. Customers without knowledge of whether a car is a "lemon" depress its price below what a quality second-hand car would be.

Related problems in insurance are adverse selection , such that those at most risk are most likely to insure say reckless drivers , and moral hazard , such that insurance results in riskier behaviour say more reckless driving. Both problems may raise insurance costs and reduce efficiency by driving otherwise willing transactors from the market " incomplete markets ". Moreover, attempting to reduce one problem, say adverse selection by mandating insurance, may add to another, say moral hazard. Information economics , which studies such problems, has relevance in subjects such as insurance, contract law , mechanism design , monetary economics , and health care.

The term " market failure " encompasses several problems which may undermine standard economic assumptions. Although economists categorize market failures differently, the following categories emerge in the main texts. Information asymmetries and incomplete markets may result in economic inefficiency but also a possibility of improving efficiency through market, legal, and regulatory remedies, as discussed above.

Natural monopoly , or the overlapping concepts of "practical" and "technical" monopoly, is an extreme case of failure of competition as a restraint on producers. Extreme economies of scale are one possible cause. Public goods are goods which are under-supplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time. Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality less crime, etc.

Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities. In many areas, some form of price stickiness is postulated to account for quantities, rather than prices, adjusting in the short run to changes on the demand side or the supply side. This includes standard analysis of the business cycle in macroeconomics.

Analysis often revolves around causes of such price stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples of such price stickiness in particular markets include wage rates in labour markets and posted prices in markets deviating from perfect competition. Some specialized fields of economics deal in market failure more than others. The economics of the public sector is one example. Much environmental economics concerns externalities or " public bads ". Policy options include regulations that reflect cost-benefit analysis or market solutions that change incentives, such as emission fees or redefinition of property rights.

Welfare economics uses microeconomics techniques to evaluate well-being from allocation of productive factors as to desirability and economic efficiency within an economy , often relative to competitive general equilibrium. Accordingly, individuals, with associated economic activities, are the basic units for aggregating to social welfare, whether of a group, a community, or a society, and there is no "social welfare" apart from the "welfare" associated with its individual units. Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down", that is, using a simplified form of general-equilibrium theory.

It also studies effects of monetary policy and fiscal policy. Since at least the s, macroeconomics has been characterized by further integration as to micro-based modelling of sectors, including rationality of players, efficient use of market information, and imperfect competition. Macroeconomic analysis also considers factors affecting the long-term level and growth of national income. Such factors include capital accumulation, technological change and labour force growth. Growth economics studies factors that explain economic growth — the increase in output per capita of a country over a long period of time.

The same factors are used to explain differences in the level of output per capita between countries, in particular why some countries grow faster than others, and whether countries converge at the same rates of growth. Much-studied factors include the rate of investment , population growth , and technological change. These are represented in theoretical and empirical forms as in the neoclassical and endogenous growth models and in growth accounting.

The economics of a depression were the spur for the creation of "macroeconomics" as a separate discipline. Keynes contended that aggregate demand for goods might be insufficient during economic downturns, leading to unnecessarily high unemployment and losses of potential output. He therefore advocated active policy responses by the public sector , including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle. Over the years, understanding of the business cycle has branched into various research programmes , mostly related to or distinct from Keynesianism.

The neoclassical synthesis refers to the reconciliation of Keynesian economics with neoclassical economics , stating that Keynesianism is correct in the short run but qualified by neoclassical-like considerations in the intermediate and long run. New classical macroeconomics , as distinct from the Keynesian view of the business cycle, posits market clearing with imperfect information. It includes Friedman's permanent income hypothesis on consumption and " rational expectations " theory, [] led by Robert Lucas , and real business cycle theory. In contrast, the new Keynesian approach retains the rational expectations assumption, however it assumes a variety of market failures.

In particular, New Keynesians assume prices and wages are " sticky ", which means they do not adjust instantaneously to changes in economic conditions. Thus, the new classicals assume that prices and wages adjust automatically to attain full employment, whereas the new Keynesians see full employment as being automatically achieved only in the long run, and hence government and central-bank policies are needed because the "long run" may be very long. The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labour force. The labour force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labour force.

Unemployment can be generally broken down into several types that are related to different causes. Classical models of unemployment occurs when wages are too high for employers to be willing to hire more workers. Consistent with classical unemployment, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.

Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process. While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth.

Money is a means of final payment for goods in most price system economies, and is the unit of account in which prices are typically stated. Money has general acceptability, relative consistency in value, divisibility, durability, portability, elasticity in supply, and longevity with mass public confidence. It includes currency held by the nonbank public and checkable deposits. It has been described as a social convention , like language, useful to one largely because it is useful to others.

In the words of Francis Amasa Walker , a well-known 19th-century economist, "Money is what money does" "Money is that money does" in the original. As a medium of exchange , money facilitates trade. It is essentially a measure of value and more importantly, a store of value being a basis for credit creation. Its economic function can be contrasted with barter non-monetary exchange. Given a diverse array of produced goods and specialized producers, barter may entail a hard-to-locate double coincidence of wants as to what is exchanged, say apples and a book. Money can reduce the transaction cost of exchange because of its ready acceptability. Then it is less costly for the seller to accept money in exchange, rather than what the buyer produces.

At the level of an economy , theory and evidence are consistent with a positive relationship running from the total money supply to the nominal value of total output and to the general price level. For this reason, management of the money supply is a key aspect of monetary policy. Governments implement fiscal policy to influence macroeconomic conditions by adjusting spending and taxation policies to alter aggregate demand.

When aggregate demand falls below the potential output of the economy, there is an output gap where some productive capacity is left unemployed. Governments increase spending and cut taxes to boost aggregate demand. Resources that have been idled can be used by the government. For example, unemployed home builders can be hired to expand highways. Tax cuts allow consumers to increase their spending, which boosts aggregate demand. Both tax cuts and spending have multiplier effects where the initial increase in demand from the policy percolates through the economy and generates additional economic activity. The effects of fiscal policy can be limited by crowding out. When there is no output gap, the economy is producing at full capacity and there are no excess productive resources.

If the government increases spending in this situation, the government uses resources that otherwise would have been used by the private sector, so there is no increase in overall output. Some economists think that crowding out is always an issue while others do not think it is a major issue when output is depressed. Sceptics of fiscal policy also make the argument of Ricardian equivalence. They argue that an increase in debt will have to be paid for with future tax increases, which will cause people to reduce their consumption and save money to pay for the future tax increase. Under Ricardian equivalence, any boost in demand from tax cuts will be offset by the increased saving intended to pay for future higher taxes.

Public economics is the field of economics that deals with economic activities of a public sector , usually government. The subject addresses such matters as tax incidence who really pays a particular tax , cost-benefit analysis of government programmes, effects on economic efficiency and income distribution of different kinds of spending and taxes, and fiscal politics. The latter, an aspect of public choice theory , models public-sector behaviour analogously to microeconomics, involving interactions of self-interested voters, politicians, and bureaucrats.

Much of economics is positive , seeking to describe and predict economic phenomena. Normative economics seeks to identify what economies ought to be like. Welfare economics is a normative branch of economics that uses microeconomic techniques to simultaneously determine the allocative efficiency within an economy and the income distribution associated with it. It attempts to measure social welfare by examining the economic activities of the individuals that comprise society. International trade studies determinants of goods-and-services flows across international boundaries. It also concerns the size and distribution of gains from trade. Policy applications include estimating the effects of changing tariff rates and trade quotas.

International finance is a macroeconomic field which examines the flow of capital across international borders, and the effects of these movements on exchange rates. Increased trade in goods, services and capital between countries is a major effect of contemporary globalization. Labor economics seeks to understand the functioning and dynamics of the markets for wage labor. Labor markets function through the interaction of workers and employers. Labor economics looks at the suppliers of labor services workers , the demands of labor services employers , and attempts to understand the resulting pattern of wages, employment, and income. In economics, labor is a measure of the work done by human beings. It is conventionally contrasted with such other factors of production as land and capital.

There are theories which have developed a concept called human capital referring to the skills that workers possess, not necessarily their actual work , although there are also counter posing macro-economic system theories that think human capital is a contradiction in terms. Development economics examines economic aspects of the economic development process in relatively low-income countries focusing on structural change , poverty , and economic growth. Approaches in development economics frequently incorporate social and political factors. According to various random and anonymous surveys of members of the American Economic Association , economists have agreement about the following propositions by percentage: [] [] [] [] [].

It is often stated that Carlyle gave economics the nickname "the dismal science" as a response to the late 18th century writings of The Reverend Thomas Robert Malthus, who grimly predicted that starvation would result, as projected population growth exceeded the rate of increase in the food supply. However, the actual phrase was coined by Carlyle in the context of a debate with John Stuart Mill on slavery , in which Carlyle argued for slavery, while Mill opposed it.

In The Wealth of Nations , Adam Smith addressed many issues that are currently also the subject of debate and dispute. Smith repeatedly attacks groups of politically aligned individuals who attempt to use their collective influence to manipulate a government into doing their bidding. In Smith's day, these were referred to as factions , but are now more commonly called special interests , a term which can comprise international bankers, corporate conglomerations, outright oligopolies, monopolies, trade unions and other groups.

Economics per se , as a social science, is independent of the political acts of any government or other decision-making organization; however, many policymakers or individuals holding highly ranked positions that can influence other people's lives are known for arbitrarily using a plethora of economic concepts and rhetoric as vehicles to legitimize agendas and value systems , and do not limit their remarks to matters relevant to their responsibilities. Notwithstanding, economics legitimately has a role in informing government policy. It is, indeed, in some ways an outgrowth of the older field of political economy. Some academic economic journals have increased their efforts to gauge the consensus of economists regarding certain policy issues in hopes of effecting a more informed political environment.

Often there exists a low approval rate from professional economists regarding many public policies. Policy issues featured in one survey of American Economic Association economists include trade restrictions, social insurance for those put out of work by international competition, genetically modified foods, curbside recycling, health insurance several questions , medical malpractice, barriers to entering the medical profession, organ donations, unhealthy foods, mortgage deductions, taxing internet sales, Wal-Mart, casinos, ethanol subsidies, and inflation targeting. Issues like central bank independence, central bank policies and rhetoric in central bank governors discourse or the premises of macroeconomic policies [] monetary and fiscal policy of the state , are focus of contention and criticism.

Deirdre McCloskey has argued that many empirical economic studies are poorly reported, and she and Stephen Ziliak argue that although her critique has been well-received, practice has not improved. Economics has historically been subject to criticism that it relies on unrealistic, unverifiable, or highly simplified assumptions, in some cases because these assumptions simplify the proofs of desired conclusions. Examples of such assumptions include perfect information , profit maximization and rational choices , axioms of neoclassical economics. Prominent historical mainstream economists such as Keynes [] and Joskow observed that much of the economics of their time was conceptual rather than quantitative, and difficult to model and formalize quantitatively.

In a discussion on oligopoly research, Paul Joskow pointed out in that in practice, serious students of actual economies tended to use "informal models" based upon qualitative factors specific to particular industries. Joskow had a strong feeling that the important work in oligopoly was done through informal observations while formal models were "trotted out ex post ". He argued that formal models were largely not important in the empirical work, either, and that the fundamental factor behind the theory of the firm, behaviour, was neglected. In the s, feminist critiques of neoclassical economic models gained prominence, leading to the formation of feminist economics.

Primary criticisms focus on alleged failures to account for: the selfish nature of actors homo economicus ; exogenous tastes; the impossibility of utility comparisons; the exclusion of unpaid work ; and the exclusion of class and gender considerations. Economics is one social science among several and has fields bordering on other areas, including economic geography , economic history , public choice , energy economics , cultural economics , family economics and institutional economics. Law and economics, or economic analysis of law, is an approach to legal theory that applies methods of economics to law.

It includes the use of economic concepts to explain the effects of legal rules, to assess which legal rules are economically efficient , and to predict what the legal rules will be. Political economy is the interdisciplinary study that combines economics, law, and political science in explaining how political institutions, the political environment, and the economic system capitalist, socialist , mixed influence each other. It studies questions such as how monopoly, rent-seeking behaviour, and externalities should impact government policy. Energy economics is a broad scientific subject area which includes topics related to energy supply and energy demand. Georgescu-Roegen reintroduced the concept of entropy in relation to economics and energy from thermodynamics , as distinguished from what he viewed as the mechanistic foundation of neoclassical economics drawn from Newtonian physics.

His work contributed significantly to thermoeconomics and to ecological economics. He also did foundational work which later developed into evolutionary economics. More recently, the works of Mark Granovetter , Peter Hedstrom and Richard Swedberg have been influential in this field. The professionalization of economics, reflected in the growth of graduate programmes on the subject, has been described as "the main change in economics since around ". See Bachelor of Economics and Master of Economics.

In the private sector, professional economists are employed as consultants and in industry, including banking and finance. Economists also work for various government departments and agencies, for example, the national treasury , central bank or National Bureau of Statistics. There are dozens of prizes awarded to economists each year for outstanding intellectual contributions to the field, the most prominent of which is the Nobel Memorial Prize in Economic Sciences , though it is not a Nobel Prize. Contemporary economics uses mathematics. Economists draw on the tools of calculus , linear algebra , statistics , game theory , and computer science.

From Wikipedia, the free encyclopedia. The neutrality of this article is questioned because it may show systemic bias. Please see the discussion on the talk page. Please do not remove this message until the issue is resolved. September This article is about the social science. For other uses, see Economics disambiguation. Social science. Branches and classifications. Concepts, theory and techniques. Critique of political economy Economic systems Economic growth Market National accounting Experimental economics Computational economics Game theory Operations research Middle income trap Industrial complex. By application. Notable economists. Glossary Economists Publications journals.

Main articles: History of economic thought and History of macroeconomic thought. This section is missing information about information and behavioural economics, contemporary microeconomics. Please expand the section to include this information. Further details may exist on the talk page. Main article: Classical economics. Main article: Marxian economics. Main article: Neoclassical economics. Main articles: Keynesian economics and Post-Keynesian economics. Main article: Chicago school of economics. Main article: Schools of economics.

Main articles: Microeconomics , Macroeconomics , and Mathematical economics. For the publication, see Economic Theory journal. Main articles: Econometrics and Experimental economics. Main articles: Microeconomics and Market economics. Main articles: Production economics , Opportunity cost , Economic efficiency , and Production—possibility frontier. Main articles: Division of labour , Comparative advantage , and Gains from trade. Main article: Supply and demand. Main articles: Theory of the firm , Industrial organization , Business economics , and Managerial economics. Main articles: Information economics , Game theory , and Financial economics. Main articles: Market failure , Government failure , Information economics , Environmental economics , Ecological economics , and Agricultural economics.

Main article: Welfare economics. Main article: Macroeconomics. Main article: Economic growth. Main article: Business cycle. See also: Circular flow of income , Aggregate supply , Aggregate demand , and Unemployment. Main article: Unemployment. Main articles: Inflation and Monetary policy. See also: Money , Quantity theory of money , and History of money. Main articles: Fiscal policy , Government spending , and Taxation. Main article: Public economics.

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Main article: Economist. Business portal. The latter includes wages and labour maintenance, money, and inputs from land, mines, and fisheries associated with production. Besides this knowledge, the merchant must also understand the processes of his art. He must be acquainted with the commodities in which he deals, their qualities and defects, the countries from which they are derived, their markets, the means of their transportation, the values to be given for them in exchange, and the method of keeping accounts. The same remark is applicable to the agriculturist, to the manufacturer, and to the practical man of business; to acquire a thorough knowledge of the causes and consequences of each phenomenon, the study of political economy is essentially necessary to them all; and to become expert in his particular pursuit, each one must add thereto a knowledge of its processes.

It does not attempt to pick out certain kinds of behaviour, but focuses attention on a particular aspect of behaviour, the form imposed by the influence of scarcity. Robbins , p. Oxford University Press. ISBN Stiglitz classifies market failures as from failure of competition including natural monopoly , information asymmetries , incomplete markets , externalities , public good situations, and macroeconomic disturbances in "Chapter 4: Market Failure".

Understanding Power. Archived from the original on 14 October Oxford Living Dictionaries. Oxford English Dictionary Online ed. Subscription or participating institution membership required. Economics , p. Essays in Positive Economics. University of Chicago Press. S2CID Applied regression analysis for business and economics. OCLC Health Policy. PMID Engineering Economics. ProQuest ebrary. Fiscal Tiers: the economics of multi-level government. National Bureau of Economic Research. The World Bank. A Treatise on the Family , Enlarged edition.

Description and preview. Economic Analysis of Law. Wolters Kluwer. The Theory of Moral Sentiments. Raphael and A. Macfie eds. The Idea of Justice. Belknap Press. Journal of Economic Literature. War with Iraq: Costs, Consequences, and Alternatives. Archived from the original PDF on 2 February Retrieved 21 October In Durlauf, Steven N. The New Palgrave Dictionary of Economics. The New Palgrave Dictionary of Economics second ed.

United Nations Environment Programme. Retrieved 27 October Volume 1. SAGE Publications. The Economics of Industry. The Theory of Political Economy second ed. Macmillan and Co. Journal of Economic Perspectives. JSTOR A Treatise on Political Economy. Grigg and Elliot. Fraser's Magazine. An Essay on the Principle of Population. London: J. Principles of Economics. Macmillan and Company. Ludwig von Mises Institute. October Scandinavian Journal of Economics. The Economic Approach to Human Behavior. Huffington Post. Edward Elgar Publishing. Economic analysis before Adam Smith: Hesiod to Lessius. History of Economic Analysis. Economic Theory in Retrospect fifth ed. Cambridge University Press. Deardorffs' Glossary of International Economics.

University of Michigan. June Journal of Political Economy. December Selected Papers, No. Graduate School of Business, University of Chicago. II: ch. Johnson Publisher. The Ultimate Resource. Princeton University Press. The Ultimate Resource 2. On the Principles of Political Economy and Taxation. John Murray. Principles of Political Economy. John W. Parker Publisher. The New York Times. Lionel Robbins's essay on the Nature and Significance of Economic Science, 75th anniversary conference proceedings.

Political Economy: A Comparative Approach second ed. III first ed. April Keynes and the "Classics": A Suggested Interpretation". Collison A bank buying protection can also use a CDS to free regulatory capital. This frees resources the bank can use to make other loans to the same key customer or to other borrowers. Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons. In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables. Although credit default swaps have been highly criticized for their role in the recent financial crisis , most observers conclude that using credit default swaps as a hedging device has a useful purpose.

However, if its outlook worsens then its CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i. An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain situations.

Therefore, a basic strategy would be to go long on the CDS spread by buying CDS protection while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity. An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a Leveraged buyout LBO.

Frequently this leads to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium. Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignment in spreads may occur due to technical reasons such as:. The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades attempt to exploit this difference to make a profit, however hedging a bond with a CDS does have irreducible risks which should be considered when making basis trades.

Forms of credit default swaps had been in existence from at least the early s, [50] with early trades carried out by Bankers Trust in A team of J. Morgan bankers led by Blythe Masters then sold the credit risk from the credit line to the European Bank of Reconstruction and Development in order to cut the reserves that J. Morgan was required to hold against Exxon's default, thus improving its own balance sheet. At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in connection with their lending activities. Banks also saw an opportunity to free up regulatory capital. The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw trading opportunities in credit default swaps.

By , investors as speculators, rather than banks as hedgers, dominated the market. Although speculators fueled the exponential growth, other factors also played a part. An extended market could not emerge until , when ISDA standardized the documentation for credit default swaps. Explosive growth was not without operational headaches. On September 15, , the New York Fed summoned 14 banks to its offices. Billions of dollars of CDS were traded daily but the record keeping was more than two weeks behind. Since default is a relatively rare occurrence historically around 0. The market for Credit Default Swaps attracted considerable concern from regulators after a number of large scale incidents in , starting with the collapse of Bear Stearns.

In the days and weeks leading up to Bear's collapse, the bank's CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital, which eventually led to its forced sale to JP Morgan in March. An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear's collapse; i. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions.

Dealers generally attempt to remain risk-neutral, so that their losses and gains after big events offset each other. The CDS on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in that triggered payouts. In there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter OTC. This led to recent calls for the market to open up in terms of transparency and regulation.

Intercontinental's clearing houses guarantee every transaction between buyer and seller providing a much-needed safety net reducing the impact of a default by spreading the risk. ICE collects on every trade. Terhune Bloomberg Business Week Litan, cautioned however, "valuable pricing data will not be fully reported, leaving ICE's institutional partners with a huge informational advantage over other traders.

In the U. Securities and Exchange Commission granted an exemption for Intercontinental Exchange to begin guaranteeing credit-default swaps. The early months of saw several fundamental changes to the way CDSs operate, resulting from concerns over the instruments' safety after the events of the previous year. According to Deutsche Bank managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few months".

By late processes had been introduced allowing CDSs that offset each other to be cancelled. Two of the key changes are:. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear. Speaking before the changes went live, Sivan Mahadevan, a derivatives analyst at Morgan Stanley, [75] one of the backers for IntercontinentalExchange's subsidiary, ICE Trust in New York, launched in , claimed that.

A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. Trading will be much easier We also feel like over time we'll see the creation of different types of products Mahadevan cited in Bloomberg It launched Single Name clearing in Dec By the end of , banks had reclaimed much of their market share; hedge funds had largely retreated from the market after the crises. On March 3, its proposed acquisition of Clearing Corp. Clearing Corp. SEC spokesperson John Nestor stated. For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its exemptive requests.

Clearnet Ltd. As of Jan. Intercontinental said in the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements. A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. In April , hedge fund insiders became aware that the market in credit default swaps was possibly being affected by the activities of Bruno Iksil , a trader at J.

Heavy opposing bets to his positions are known to have been made by traders, including another branch of J. Morgan, who purchased the derivatives offered by J. Morgan in such high volume. The disclosure, which resulted in headlines in the media, did not disclose the exact nature of the trading involved, which remains in progress. A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association. The period over which default protection extends is defined by the contract effective date and scheduled termination date. The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract , and for performing various calculation and administrative functions in connection with the transaction.

By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high-yield corporate reference entities typically do not.

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions other than Rule A , that it be of a standard currency and that it not be subject to some contingency before becoming due. The premium payments are generally quarterly, with maturity dates and likewise premium payment dates falling on March 20, June 20, September 20, and December The European sovereign debt crisis resulted from a combination of complex factors, including the globalisation of finance ; easy credit conditions during the — period that encouraged high-risk lending and borrowing practices; the — global financial crisis ; international trade imbalances; real-estate bubbles that have since burst; the — global recession ; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socialising losses.

The Credit default swap market also reveals the beginning of the sovereign crisis. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings i. During the Greek sovereign debt crisis, one important issue was whether the restructuring would trigger Credit default swap CDS payments. European Central Bank and the International Monetary Fund negotiators avoided these triggers as they could have jeopardized the stability of major European banks who had been protection writers.

An alternative could have been to create new CDS which clearly would pay in the event of debt restructuring. The market would have paid the spread between these and old potentially more ambiguous CDS. This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco 's restructuring in led to the credit event's removal from North American high yield trades. As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled.

The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. This is because many parties made CDS contracts for speculative purposes, without actually owning any debt that they wanted to insure against default. The trade confirmation produced when a CDS is traded states whether the contract is to be physically or cash settled. When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction also known as a credit-fixing event may be held to facilitate settlement of a large number of contracts at once, at a fixed cash settlement price.

During the auction process participating dealers e. A second stage Dutch auction is held following the publication of the initial midpoint of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association ISDA , who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington Mutual.

Below is a list of the auctions that have been held since There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to herein as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds. Under the probability model, a credit default swap is priced using a model that takes four inputs; this is similar to the rNPV risk-adjusted NPV model used in drug development :.

If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end:. To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome.

The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.

To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give. In the "no-arbitrage" model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage. Both analyses make simplifying assumptions such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default , which may invalidate the no-arbitrage assumption.

However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of , and the swap spread is 70 basis points, then a CDS contract should trade at However, there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor.

The difference between the theoretical model and the actual price of a credit default swap is known as the basis. Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have been claims that CDSs exacerbated the global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG. In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome.

However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default. Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the General Motors Chapter 11 reorganization , because certain bondholders might benefit from the credit event of a GM bankruptcy due to their holding of CDSs.

Critics speculate that these creditors had an incentive to push for the company to enter bankruptcy protection. Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, reducing the net cashflows on the days after the auction. Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis; that CDS contracts have been acting to distribute risk just as was intended; and that it is not CDSs themselves that need further regulation but the parties who trade them.

Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man or sometimes, so it seems, madmen. To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one's counterparty.

The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection. The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. During the financial crisis , counterparties became subject to a risk of default, amplified with the involvement of Lehman Brothers and AIG in a very large number of CDS transactions. This is an example of systemic risk , risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.

For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. Chains of CDS transactions can arise from a practice known as "netting". However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C.

The problem lies if one of the companies in the chain fails, creating a " domino effect " of losses. For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company.

Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B. As described above , the establishment of a central exchange or clearing house for CDS trades would help to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers. The U. There is a risk of having CDS recharacterized as different types of financial instruments because they resemble put options and credit guarantees. If a CDS is a notional principal contract, pre-default periodic and nonperiodic payments on the swap are deductible and included in ordinary income.

The thrust of this criticism is that Naked CDS are indistinguishable from gambling wagers, and thus give rise in all instances to ordinary income, including to hedge fund managers on their so-called carried interests, [] and that the IRS exceeded its authority with the proposed regulations. This is evidenced by the fact that Congress confirmed that certain derivatives, including CDS, do constitute gambling when, in , to allay industry fears that they were illegal gambling, [] it exempted them from "any State or local law that prohibits or regulates gaming.

The accounting treatment of CDS used for hedging may not parallel the economic effects and instead, increase volatility. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce considerable volatility into the income statement and balance sheet as the CDS changes value over its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS.

One can try to account for the CDS as a hedge under FASB [] but in practice that can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular CDS that was bought. A new type of default swap is the "loan only" credit default swap LCDS. This is conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of May 22, , for the most widely traded LCDS form, which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement.

The auction method is essentially the same that has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any additional steps following a credit event i. Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name. From Wikipedia, the free encyclopedia. Buyer purchased a CDS at time t 0 and makes regular premium payments at times t 1 , t 2 , t 3 , and t 4. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t 5 , t 6 and so on until the end of the contract at time t n.

However, if the associated credit instrument suffered a credit event at t 5 , then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller. Parts of this article those related to legality of naked CDS in Europe need to be updated. Please help update this article to reflect recent events or newly available information. November Main article: Causes of the European sovereign-debt crisis. See also: Category:Systemic risk.

University of Pennsylvania. Retrieved January 31, FT Alphaville. Retrieved January 5, Archived from the original PDF on March 7, Retrieved April 8, December 31, Retrieved March 12, IMF Working Papers. S2CID Retrieved April 25, Deutsche Bank Research: Current Issues. Retrieved December 9, Securities and Exchange Commission. Retrieved April 2, University of Cincinnati Law Review.

Cincinnati, Ohio: University of Cincinnati. SSRN March 23, Archived from the original on April 29, Retrieved April 22, Federal Reserve Bank of New York. Retrieved September 13, Journal of Banking and Finance. Retrieved January 13, Product description: Credit default swaps". Archived from the original on April 16, Retrieved March 26, A Primer on Credit Default Swaps". Financial Update. Archived from the original on July 23, Retrieved March 31, Harrington July 24, Salon Media Group. Retrieved April 24, Derivatives and Alternative Investments. Boston: Pearson Custom Publishing. ISBN September 23, Retrieved March 17, Retrieved November 3, If a default occurs, the party providing the credit protection — the seller — must make the buyer whole on the amount of insurance bought.

If the fund manager acts as the protection seller under a CDS, there is some risk of breach of insurance regulations for the manager However, if certain requirements are met, credit derivatives do not qualify as an agreement of non-life insurance because such an arrangement would in those circumstances not contain all the elements necessary to qualify it as such. Retrieved April 3, Archived from the original PDF on May 27, Archived from the original on April 14, Retrieved April 20, Bank for International Settlements.

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