Implications for Risk Management and Regulation : A Study of Long-Term Dependence in the Credit Default Swap (CDS) Indices Market

Credit Default Swaps, as the name indicates, are credit instruments used by banks, non-banking financial institutions, hedge funds and investors, so as to shift risk from one party to another (Mengle, 2007). These instruments are rife with controversy and opposing arguments with regard to pertinent regulatory standards aimed at ensuring requisite checks and balances in the system. The authors of this study do not wish to take sides in such arguments. Rather, the authors wish to shed light upon the nature and degree of market risk inherent in CDS instruments, and hence help regulators to calculate the level of regulatory reserves that ought to be mandated to avert extreme disasters or meltdowns in the future. In other words, the authors wish to ascertain how high a dam of dollar reserves ought to be constructed to avoid the equivalent of a 100 year flood