Financial Innovation and Risk Management: An Introduction to Credit Derivatives

By Brandon, Kyle; Fernandez, Frank A. | Journal of Applied Finance, Spring 2005 | Go to article overview

Financial Innovation and Risk Management: An Introduction to Credit Derivatives


Brandon, Kyle, Fernandez, Frank A., Journal of Applied Finance


In recent years, discussions of financial innovation and risk management have invariably turned to credit derivatives. Although these instruments are drawing increasing attention1 and growing in importance2, credit derivatives remain an obscure subject for many participants in the financial markets. The following is drawn largely from a presentation made by Frank Fernandez, Senior Vice President, Chief Economist and Director of Research, Securities Industry Association, at the Rutgers Business School conference on Financial Innovation: Session IV: Financial Innovation and Risk Management-Credit Derivatives, which took place in New York City on November 12, 2004.

Credit derivatives are financial products that:

*Isolate credit risk3 (from other forms of risk such as market risk or operational risk) of a particular asset or credit (known as the reference asset or reference credit) and transfers that risk from one party to another;

*Have payoffs that are contingent on the occurrence of a credit event, such as failure to pay, obligation acceleration, restructuring, moratorium and repudiation; and,

*Reflect the market's assessment of the likelihood of the reference asset experiencing a credit event within a certain time frame and the expected value of the reference asset after the event (recovery value).

The over-the-counter credit derivatives market described below dates to 1991 (see Smithson and Holappa, 1996), but traces its roots to options, in the form of bond insurance, that pay in the event of default of a particular credit, which have been around for more than three decades.4 The outstanding notional value of the credit derivatives market grew from approximately $180 million in 1997 to more than $1 trillion in 2001, before reaching an estimated $5 trillion at end-2004 (see Figure I).5 Although banks seeking to hedge credit risk in their loan portfolios led growth, the size and liquidity of the credit derivatives market developed in response to a broad range of participants seeking to hedge and take credit risk. Current market players include banks, securities firms, non-financial corporations, insurance/reinsurance companies, and hedge funds. One of the most notable changes in the composition of credit derivatives market players is the increasing role of hedge funds and the decrease in securities firms as a share of total participation, as the Figures 2 and 3 demonstrate.6

The credit-derivatives market is useful because it provides:

*Liquidity to the cash market in times of stress;

*Liquidity to individual credits under stress;

*A conduit for information across markets for distinct asset classes;

*A means to isolate credit risk from other risks inherent in ownership of credit instruments;

*A variety of off-balance sheet instruments (except when embedded in structured notes) that offer flexibility in terms of leverage; and,

*An efficient way to short a credit without incurring the risk of a "short squeeze". (Credit Derivatives: A Primer, 2003)

By rationalizing pricing of credit products, the development of the credit derivatives market has promoted efficiency. Financial institutions that have originated, serviced, and held credit risk of various types of financial assets such as bonds, syndicated loans and mortgages can now, with the development of credit derivatives, transfer the risks of these assets to the most efficient holders. Even traditional lending institutions have increasingly become originators and servicers of, rather than investors in, credit products. Credit derivatives provide "market completion" by providing access to credit exposure from sources that would not be available otherwise. Credit derivatives have broken down the barriers in a variety of important ways: between product segments (bonds and loans); between geographies (standard global documentation); and, between market participants (those active in securities, loan and derivatives markets). …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Financial Innovation and Risk Management: An Introduction to Credit Derivatives
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.