Introduction to Credit Derivatives

Abstract

The risk of a counterparty of a financial contract failing to live up to their obligations is real and can have far-reaching consequences. The financial system is predicated on the fact that when one buys an option or bond or enters into a swap with a counterparty, the expectation is that they will honor all contingent or promised cash flows from the financial instruments in question. The failure to meet a payment of any sort is considered a credit event and is called a default. Defaults may occur when companies declare bankruptcy and can no longer meet their debt obligations in terms of interest and principal payments. Government entities—such as countries, states, and municipalities—all can issue debt and therefore can default on this debt. Individuals default when they cannot make their mortgage or credit card payments. The risk of large counterparties such as Lehman Brothers and Bear Stearns defaulting (during the 2008 subprime crisis) can have potentially devastating effects on the financial system as a whole. Large banks such as Citi and Bank of America defaulting can lead to a “run on cash” from their ordinary depositors and potential riots in the streets. The risk of the whole financial system collapsing due to a few events such as the 2008 subprime crisis is known as systemic risk. Therefore, the US government along with the Fed bailed out the big banks during the 2008 subprime crisis. Some have argued that this bailout has created an environment of moral hazard. If banks know that they will get bailed out, they will take large risks without facing the downside consequences of taking those risks. There is always a counterplay between systemic risk and moral hazard. For instance, individuals defaulting on their mortgages does not create systemic risk; therefore, they are rarely bailed out, leading to no moral hazard issues. Airlines, on the other hand, are crucial for a country such as the United States and therefore will be bailed out, potentially leading to a moral hazard outcome. Most governments will accept the moral hazard risk over the systemic risk. The last time a US president chose not to bail out the financial system was after the stock market crash of October 29, 1929 (Black Tuesday). This led to the Great Depression, which affected the whole world and lasted almost ten years.