Role of Credit Derivatives to Financial Crisis

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Rode of credit derivatives

Credit derivatives – financial instruments that allow one to assume or cede credit risk exposure. Credit derivatives are bilateral contracts between a buyer and a seller, whereby the seller sells protection against the credit risk of the reference entity (i.e. corporate, sovereign or any other legal entity which incurs debt). Credit derivatives played a major role in the financial crisis of 2008, with many banks, investment banks and insurers incurring unexpectedly large losses from credit derivatives. In some cases, the organizations failed and others required massive government bailouts to remain solvent. From subsequent comments it became clear that many board members, risk officers and other executives did not clearly understand the risks involved in the credit derivatives they traded. Credit derivatives allow investors to express their credit more efficiently and flexibly, and mitigate (reduce) credit risk by spreading it among a wider group of investors. But all these circumstances magnified systemic risk, especially given the difficulty of identifying counterparties and pinpointing where credit risk ultimately resided. Some complain that fair-value accounting requirements exacerbated the credit crisis for many financial institutions. But some industry leaders counter that if banks and other institutions had properly valued their risk exposures at the outset, they would have been in a better position to manage and reduce those exposures when the crisis hit. Credit derivatives instruments made mortgage lending problems worse, shifting risk that is the basic property of derivatives in directions that became so complex that neither the designer nor the buyer of these instruments apparently understood the risks they imposed and implicated derivative owners in risky contingencies they did not realize they were assuming. Derivatives as well as mortgage-backed securities were difficult to price. I...
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