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Credit derivatives and risk management

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Abstract

The striking growth of credit derivatives suggests that market participants find them to be useful tools for risk management. I illustrate the value of credit derivatives with three examples. A commercial bank can use credit derivatives to manage the risk of its loan portfolio. An investment bank can use credit derivatives to manage the risks it incurs when underwriting securities. An investor, such as an insurance company, asset manager, or hedge fund, can use credit derivatives to align its credit risk exposure with its desired credit risk profile.> However, credit derivatives pose risk management challenges of their own. I discuss five of these challenges. Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. They can create counterparty credit risk that itself must be managed. Complex credit derivatives rely on complex models, leading to model risk. Credit rating agencies interpret this complexity for investors, but their ratings can be misunderstood, creating rating agency risk. The settlement of a credit derivative contract following a default can have its own complications, creating settlement risk. For the credit derivatives market to continue its rapid growth, market participants must meet these risk management challenges.

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  • Michael S. Gibson, 2007. "Credit derivatives and risk management," Finance and Economics Discussion Series 2007-47, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2007-47
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    1. Michael S. Gibson, 2004. "Understanding the risk of synthetic CDOs," Finance and Economics Discussion Series 2004-36, Board of Governors of the Federal Reserve System (U.S.).
    2. Klemperer, Paul, 2002. "How (not) to run auctions: The European 3G telecom auctions," European Economic Review, Elsevier, vol. 46(4-5), pages 829-845, May.
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    1. Eyssell, Thomas & Fung, Hung-Gay & Zhang, Gaiyan, 2013. "Determinants and price discovery of China sovereign credit default swaps," China Economic Review, Elsevier, vol. 24(C), pages 1-15.
    2. Gheorghe VOINEA & Sorin Gabriel ANTON, 2009. "Lessons from the Current Financial Crisis. A Risk Management Approach," Review of Economic and Business Studies, Alexandru Ioan Cuza University, Faculty of Economics and Business Administration, issue 3, pages 139-147, May.
    3. Hirtle, Beverly, 2009. "Credit derivatives and bank credit supply," Journal of Financial Intermediation, Elsevier, vol. 18(2), pages 125-150, April.
    4. M. Kabir Hassan & Thiti S. Ngow & Jung Suk-Yu, 2011. "Determinants of Credit Default Swaps in International Markets," NFI Working Papers 2011-WP-01, Indiana State University, Scott College of Business, Networks Financial Institute.
    5. Markose, Sheri & Giansante, Simone & Shaghaghi, Ali Rais, 2012. "‘Too interconnected to fail’ financial network of US CDS market: Topological fragility and systemic risk," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 627-646.
    6. Akira Nishimura, 2016. "Foreign Exchange Risk and Profit Improvement in the Comprehensive Profit Opportunity and Lost Opportunity Control Model," International Journal of Business and Management, Canadian Center of Science and Education, vol. 11(4), pages 1-1, March.

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    Keywords

    Risk management; Credit derivatives;

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