Credit Derivatives: New Financial Instruments for Controlling Credit Risk

By Neal, Robert S. | Economic Review - Federal Reserve Bank of Kansas City, Second Quarter 1996 | Go to article overview

Credit Derivatives: New Financial Instruments for Controlling Credit Risk


Neal, Robert S., Economic Review - Federal Reserve Bank of Kansas City


One of the risks of making a bank loan or investing in a debt security is credit risk, the risk of borrower default. In response to this potential problem, new financial instruments called credit derivatives have been developed in the past few years. Credit derivatives can help banks, financial companies, and investors manage the credit risk of their investments by insuring against adverse movements in the credit quality of the borrower. If a borrower defaults, the investor will suffer losses on the investment, but the losses can be offset by gains from the credit derivative. Thus, if used properly, credit derivatives can reduce an investor's overall credit risk.

Estimates from industry sources suggest the credit derivatives market has grown from virtually nothing two years ago to about $20 billion of transactions in 1995. This growth has been driven by the ability of credit derivatives to provide valuable new methods for managing credit risk. As with other customized derivative products, however, credit derivatives expose their users to risks and regulatory uncertainty. Controlling these risks is likely to be an important factor in the future development of the credit derivatives market.

This article provides information on the rationale and use of credit derivatives. The first section of the article describes how to measure credit risk, whom it affects, and the traditional strategies used to manage it. The second section shows how credit derivatives can help manage credit risk. The third section examines the risks and regulatory issues associated with credit derivatives.

CREDIT RISK

Credit risk is important to banks, bond issuers, and bond investors. If a firm defaults, neither banks nor investors will receive their promised payments. While there are a variety of methods for managing credit risk, these methods are typically insufficient to reduce credit risk to desired levels. This section defines credit risk, describes how it can be measured, and shows how it affects bond issuers, bond investors, and banks. The section also describes the techniques most commonly used to manage credit risk, such as loan underwriting standards, diversification, and asset securitization.

What is credit risk?

Credit risk is the probability that a borrower will default on a commitment to repay debt or bank loans. Default occurs when the borrower cannot fulfill key financial obligations, such as making interest payments to bondholders or repaying bank loans. In the event of default, lenders-bondholders or banks-suffer a loss because they will not receive all the payments promised to them.l

Credit risk is influenced by both business cycles and firm-specific events. Credit risk typically declines during economic expansions because strong earnings keep overall default rates low. Credit risk increases during economic contractions because earnings deteriorate, making it more difficult to repay loans or make bond payments. Firm-specific credit risk is unrelated to business cycles. This risk arises from events specific to a firm's business activities or its industry, events such as product liability lawsuits. For example, when the health hazards of asbestos became known, liability lawsuits forced JohnsManville, a leading asbestos producer, into bankruptcy and to default on its bonds.

A broad measure of a firm's credit risk is its credit rating. This measure is useful for categorizing companies according to their credit risk. Rating firms, such as Moody's Investors Services, assign a credit rating to a company based on an analysis of the company's financial statements. Credit ratings range from Aaa for firms of the highest credit quality, to Ccc for firms likely to default.2

A more quantitative measure of credit risk is the credit risk premium. The credit risk premium is the difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security, such as a U. …

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