Financial Innovation and Risk Management: An Introduction to Credit Derivatives

Article excerpt

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). …