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Reading, "Risky Business" (Chapter 13)

This reading, " Risky Business." asks whether credit derivatives and other recent credit market innovations have made the financial system more stable or have instead made it more risky and sensitive to shocks. It describes some of the new derivative instruments and presents a variety of views on theses issues.

  1. Define the following terms used in the reading:
    1. derivatives
    2. hedge
    3. credit default swap
    4. synthetic collateralized debt obligation
    5. tranches
    6. liquidity
    7. primary market
    8. secondary market
    9. hedge funds
    10. market discipline

  2. How does a credit default swap work?
    1. Is the Great Moderation beneficial to the economy? Why?
    2. Why are policymakers interested in ascertaining its causes?

  3. How can credit derivatives and other innovations make the financial system more stable? Do Kroszner and Geithner agree with this view? Explain.
  4. Why is liquidity an important characteristic of markets? Are credit market participants sufficiently diverse to insure liquidity? Explain.
  5. Why is managing risk especially difficult when new credit market instruments are involved?
  6. What criticisms do some observers express about the new credit derivatives and other credit market innovations? Should policymakers regulate these new instruments and the market participants that buy and sell them?
Source: "Risky Business." Vanessa Sumo, Region Focus, Federal Reserve Bank of Richmond, Summer 2007, 16-19.

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