Credit risk is arguably the most significant form of risk capital market participants face. It is often unmanaged, or at best poorly managed, and not well understood. It tends to be situation-specific, and it does not easily fit to the concept of modern portfolio theory. And yet, it is an important consideration in most business and financial transactions. Managing credit risk exposure more effectively is crucial to improving capital market liquidity and efficiency. Credit derivatives have emerged in the 1990s as a useful risk management tool. They allow market participants to separate credit risk from the other types of risk and to manage their credit risk exposure by selectively transfer-ring unwanted credit risk to others. This distinguishing of credit risk from other types of risk creates new opportunities for both hedging and investing. Introduced in 1991, the volume of outstanding credit derivatives now exceeds $100 billion notional amount by some estimates. Their use continues to expand, and the participants in this market now include banks, industrial corporations, hedge funds, insurance companies, mutual funds, and pension funds. Credit derivatives have the potential to alter fundamentally the way credit risk is originated, priced, and managed; they permit investors to diversify their credit risk exposure; and they enable the credit markets to reallocate credit risk exposures to those market participants who are best equipped to handle them. But as credit derivative use has grown, so has concern about whether users really understand the risks involved and whether these instruments are fairly priced. Our paper will try to explains how credit derivatives work and how companies and investors can use them to manage their exposure to credit risk more effectively and to enhance their investment returns through better diversification. A credit derivative is a privately negotiated contract the value of which is derived from the credit risk of a bond, a bank loan, or some other credit instrument . Market participants can use credit derivatives to separate default risk from other forms of risk, such as currency risk or interest rate risk. The value of a credit derivative is linked to the change in credit quality of some underlying fixed-income security, usually a bond, a note, or a bank loan. As credit quality changes, so does the value of a fixed-income security. Deterioration (improvement) in credit quality raises (lowers) the yield investors require and reduces (increases) the price of the bond, other factors remaining the same. A credit derivative can be used to hedge this risk. For example, a bank can use credit derivatives to reduce its exposure to the risk of a loan customer’s defaulting. It can transfer this risk to other parties, for a fee, while keeping the loans to this customer on its books. The extent of the protection the hedge affords depends on the nature of the derivative selected. Credit derivatives are generally short-term in nature, usually having a time to expiration of between one and three years initially. As the credit derivatives market develops, longer-dated instruments may become more readily available. Similar developments have taken place in the interest rate swap and currency swap markets.
Credit default swaps can be very complex and expensive to arrange but nonfinancial companies now under pressure to explore them more actively to manage their credit risk.
A credit default swap is a bilateral financial contract in which a buyer of protection pays a periodic fixed fee to a seller of protection. In return, the seller incurs a contractual obligation to pay a one-time payment in the event of a default on the underlying reference security. The onetime payment could be in the form of a cash settlement, or a physical settlement. If the underlying reference security in question is a bond, then a payment of cash equal to the decline in the market value of the bond is paid to the buyer. However,...
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