Credit Derivatives Market Research Articles

Credit Derivatives, Disintermediation, and Investment Decisions

The credit derivatives market provides a liquid but opaque forum for secondary market trading of banking assets. I show that, when entrepreneurs rely on the certification value of bank debt to obtain cheap bond market finance, the existence of a credit derivatives market may cause them to issue sub-investment grade bonds instead and engage in second-best behavior. Credit derivatives can therefore cause disintermediation and thus reduce welfare. I argue that this effect can be most effectively countered by the introduction of reporting requirements for credit derivatives.

Managing Portfolio Risk with Credit Derivatives

Although futures, swaps, and options provide effective means for managing most of the main types of fixed-income portfolio risk, until relatively recently investors lacked the means for hedging credit risk. The advent and rapid growth of the credit derivatives market addressed this need. Critically, credit derivatives also provide an alternative source of liquidity to a largely inefficient corporate bond market.

The relationship between credit default swap spreads, bond yields, and credit rating announcements

A company’s credit default swap spread is the cost per annum for protection against a default by the company. In this paper we analyze data on credit default swap spreads collected by a credit derivatives broker. We first examine the relationship between credit default spreads and bond yields and reach conclusions on the benchmark risk-free rate used by participants in the credit derivatives market. We then carry out a series of tests to explore the extent to which credit rating announcements by Moody’s are anticipated by participants in the credit default swap market.

Risk Reduction for Energy Project Sponsors Through Synthetic, Revenue-Neutral Diversification

Financial institutions and insurance companies account for 96% of the activity in the $4.8 trillion credit derivatives market while corporations account for a mere 4%. This article makes a case for? synthetic, revenue-neutral diversification? as a method for energy firms to manage the credit risk in their long-term power-purchase agreements (PPAs). Synthetic, revenue-neutral diversification involves a firm buying insurance on assets in its portfolio and paying the associated insurance premium by simultaneously selling insurance to another firm, thus enabling it to avoid any cash expense. The primary objective of synthetic, revenue-neutral diversification is implicitly to change the firm?s asset portfolio and to increase diversification without reducing the firm?s revenues. In an example, two independent power producers use credit derivatives to diversify the geographic exposures of their PPA portfolios, thereby reducing their expected losses, improving their credit ratings, and lowering their cost of borrowing.

Using Credit Derivatives to Manage Portfolio Risk

Although futures, swaps, and options provide effective means for managing most of the main types of fixed-income portfolio risk, until relatively recently, investors lacked the means for hedging credit risk. The advent and rapid growth of the credit derivatives market addressed this need. Critically, credit derivatives also provide an alternative source of liquidity to a largely inefficient corporate bond market.

Synthetic Arbitrage CDOS

Synthetic arbitrage collateralized debt obligations (CDOs) use derivatives technology to transfer credit risk inherent in a pool of credits to capital markets investors, while at the same time exploiting spread mismatch between assets and liabilities within the transaction. Their emergence has been fueled by the explosive growth of the credit derivatives market and by their appealing features, which include short bullet maturities, brief asset accumulation periods, flexible structures, and spreads that are attractive relative to cash CDOs and corporate bonds. Despite these and many other attractions, the growth of this market has been hampered over the past few years by problems relating mainly to structure and to the quality of the underlying portfolio. Now, experience with this asset class has led to three areas of marked improvements that promise to reinvigorate this asset class: 1) portfolio asset selection methods have become more transparent and sophisticated and the ability to substitute reference credits has become more prevalent; 2) structures have evolved to balance the risks and rewards more fairly across the entire CDO capital structure; the borrowing of performance triggers from cash CDO structures has made mezzanine tranche return profiles more stable; and 3) credit default swap documentation has improved and has become standardized as it relates to the determination of a credit event and the valuation of the reference obligation post-default.

Managing Global Volatility

We define global volatility as the weighted average volatility of four major asset classes (Equities, Fixed Income, Foreign Exchange and Commodities), with weights based on Market Capitalization. Equity and Fixed Income account for 70% of the weight and we primarily focus on them. The developments in financial engineering and risk management in the last two decades has led to a spreading of risks between different institutions. Banks today are remarkably healthy with bad loans accounting for barely 10% of Bank's Equity. This is primarily because banks are net buyers of protection. Commercial banks have sold a significant slice of their risks to insurance and re-insurance companies. Now, the credit derivative market is very illiquid, primarily because there is no consensus on how to price credit derivatives. Different banks use different models and these values differ significantly. This forces the insurers/re-insurers to either use the less liquid bond market or the more liquid equity market to hedge their risks. Specifically, they go short to hedge themselves. Further, as markets fall, insurers respond by selling more, which in turn leads to points of extreme volatility and dislocation. Also the insurer makes his money on shorting equities and uses a part of this to pay back the bank the defaulted loan. The essential point to note is that the insurer can be the market maker. The bigger problem is however that the movement of risks off bank balance sheets and into the asset books of insurance companies led to a greater convergence in the way risks are valued, traded, managed and hedged. Instead of there being at least two views of risk - one privately held by the loan officers and one publicly held by the equity markets - there is now only one. This convergence results in a concentration of risks across time and markets. To combat this increase in volatility we suggest first, improving liquidity in credit derivatives by agreeing on a fair pricing method. Second, regulators have tried to impose high and 'common' standards for both banks and insurers, but to reduce risk we need diversity in its treatment. And third, to limit participation in equity markets by pension funds and insurance/re-insurance companies.

Credit Derivatives and Their Potential to Synthesize Riskless Assets

The credit derivatives market may help shape the overall financial markets for years to come. This is an overview of the credit derivatives market and an assessment of its future potential in the creation of private sector instruments. That these instruments are virtually free of default risk may be appealing to investors who now favor the safety of U.S. Treasury securities.

Credit derivatives: regulating in the jungle

The credit derivatives market is both fast‐growing and increasingly complex. This brings problems for banks and the infrastructure needed to support such products. There are also sophisticated questions of regulation. The authors bring a wealth of experience to bear on the topic and suggest a variety of ways in which the problems and opportunities can be dealt with satisfactorily.

Pricing Multiname Credit Derivatives: Heavy Tailed Hybrid Approach

In recent years, credit derivatives have become the main tool for transferring and hedging credit risk. The credit derivatives market has grown rapidly both in volume and in the breadth of the instruments it offers. Among the most complicated of these instruments are the multiname ones. These are instruments with payoffs that are contingent on the default realization in a portfolio of names. The modeling of dependent defaults is difficult because there is very little historical data available about joint defaults and because the prices of those instruments are not quoted. Therefore, the models cannot be calibrated, neither to defaults nor to prices. In this paper, we present a methodology for the estimation, simulation, and pricing of multiname contingent instruments. Our model is a hybrid of the well-known structural and reduced form approaches for modeling defaults. The dependence structure of our model is of a t-copula that possesses non-trivial tail dependence. Compared with the commonly used normal-copula,the t-copula allows for more joint extreme events, which have a big impact on the prices of multiname instruments, e.g. nth-to-default baskets and CDOs. We demonstrate this impact with nth-to-default baskets.

Understanding Credit Derivatives and their Potential to 
 Synthesize Riskless Assets

The credit derivatives market is emerging as a potentially important new development that may help shape the overall financial markets in the years to come. In this paper, I provide a brief overview of the credit derivatives market and assess its future potential in the creation of private-sector instruments that are virtually free of default risk, and, thus, may be appealing to investors who currently favor the safety of U.S. Treasury securities.

Understanding Credit Derivatives and Their Potential to Synthesize Riskless Assets

The credit derivatives market is emerging as a potentially important new development that may help shape the overall financial markets in the years to come. In this paper, I provide a brief overview of the credit derivatives market and assess its future potential in the creation of private-sector instruments that are virtually free of default risk, and, thus, may be appealing to investors who currently favor the safety of U.S. Treasury securities.

Credit derivatives in banking: Useful tools for managing risk?

We model the effects on banks of the introduction of a market for credit derivatives; in particular, credit-default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the “lemons” problem caused by banks’ superior information about the credit quality of their loans. However, we find that the introduction of a credit-derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down.

New Applications for Credit Derivatives

Credit derivatives have, to date, mainly been used to disaggregate and lay-off the static credit risk on loan portfolios (including residential mortgage loans, commercial loans, car loans, credit card receivables, and margin lending receivables), and manage syndication and subparticipation risks. Now, however, with the maturation of the credit derivatives market, new applications for credit derivatives have emerged. This is exemplified by the decisive shift in the global credit derivatives market away from vanilla credit default swaps to more exotic structures. This article discusses the new applications of credit derivatives, namely the use of credit derivatives to: hedge credit risk in MA hedge currency convertibility risk; hedge dynamic credit risk; create leveraged positions; enhance investment returns; exploit credit arbitrage opportunities; and create synthetic assets.

Credit Derivatives, Disintermediation and Investment Decisions

The credit derivatives market provides a liquid but opaque forum for secondary market trading of banking assets. I show that when entrepreneurs rely upon the certification value of bank debt to obtain cheap bond market finance, the existence of a credit derivatives market may cause them to issue sub-investment grade bonds instead, and to engage in second-best behaviour. Credit derivatives can therefore cause disintermediation and thus reduce welfare. I argue that this effect can be most effectively countered by the introduction of reporting requirements for credit derivatives.

There’s a new set of definitions in town

Chronicles the International Swaps and Dealers Association’s (ISDA’s) compliance with the new credit derivative definitions. Adumbrates that the objectives are: to promote more transparency and liquidity in the market; provide objective assessment; and offers a range of choice for three things which are highlighted and discussed. Examines the definitions in depth giving lucid explanations. Concludes that the credit derivatives market has a strong base for future growth.

Credit Derivatives in Banking: Useful Tools for Managing Risk?

We model the effects on banks of the introduction of a market for credit derivatives--in particular, credit default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans would trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the "lemons" problem caused by banks' superior information about the credit quality of their loans. However, we find that the introduction of a credit derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down. In this case, the existence of a credit derivatives market will lead to a greater risk of bank insolvency.