Credit Derivatives: An Introduction
Credit derivatives are the most important financial innovation in the field of credit risk management. These derivative instruments have been created quite recently. They have only been traded for a couple of decades as compared to other instruments like stocks and bonds which have been around for centuries. Within this short period of time, credit derivatives have made a mark for themselves. Today, there is a thriving market for these financial instruments across the world. This is despite the fact that many credit derivatives faced very bad publicity during the 2008 crisis.
In this article, we will have a closer look at what credit derivatives are and how they have transformed the field of credit risk management.
Why are Credit Derivatives Needed?
For many years, credit risk was illiquid and untradeable. However, this became a problem as it started deterring people from making investments. This is because there are different people in the market who have varying levels of risk tolerance.
During the lifecycle of debt, it is quite possible that its risk profile may increase and it may no longer be palatable to another firm. Hence, there is a need to have a vibrant and liquid market where people with different underlying risk profiles can trade. This is what is provided by credit derivatives. Since these derivatives fill a latent need, they are sought after by many people in the market.
Benefits of Credit Derivatives
Some of the underlying benefits of credit derivatives that make them lucrative for investors have been listed below:
Problems With Credit Derivatives
There are several benefits to buying credit derivatives. However, there are certain problems as well. They have been listed below:
The bottom line is that credit derivatives are very useful products. They can perform many functions and save organizations some money as well. However, one has to be careful while trading in credit derivatives since the market is unregulated in many parts of the world. This means that the counterparty should be carefully chosen to ensure that the insurance coverage provided is effective and adequate.
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