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:

• Liquidity: Credit derivatives have transformed the market because they have provided a lot of liquidity to a market that has been starved for liquidity for a very long time. With the advent of credit derivatives, metrics that seemed untradable in the past have now become tradable. For instance, using credit derivatives, companies can now obtain protection against changes caused by an increase or decrease in the repo rate.

• Regulatory Costs: Banks are one of the biggest consumers and beneficiaries of credit derivatives. This is because a lot of bank’s capital is tied up as reserved because of the loans that they made. This restricts their ability to generate more loans and interest income thereby limiting their profit. Hence, banks purchase a lot of credit derivatives. This protects them from the downside risks in case an adverse credit event happens. Also, if they purchase these credit derivatives, they no longer have to reserve a lot of capital to mitigate credit risks. The end result is that regulatory costs are reduced and money is freed up to make more loans!

• Transaction Costs: Credit derivatives help companies save money by saving on transaction costs. Many times companies want to trade on the spread between two interest rates. In such cases, they have to buy securities with one interest rate and sell the ones with another rate. However, instead, if they purchase credit derivatives, they can directly trade the spread. Hence, they don’t have to make two transactions and bear the associated transaction cost.

• Unbundling of Risks: When investors buy a security, they have a wide variety of risks bundled together. For instance, there is market risk and credit risk involved. Credit derivatives help people unbundle the risks. This is because when they buy credit risks, they insure themselves against the risk of an adverse credit event. Hence, they only need to focus on adverse market movements. This unbundling of risks allows investors to closely align their portfolios with their desired risk profiles. In the absence of credit derivatives, this would have been impossible.

Problems With Credit Derivatives

There are several benefits to buying credit derivatives. However, there are certain problems as well. They have been listed below:

• Information Asymmetry: Firstly, the credit derivatives market is far from fair. The parties selling protection in lieu of a premium have far more information as compared to the party which is buying the protection. This information asymmetry makes it impossible for both parties to price the risks correctly. Hence, over time the instruments are almost never fairly priced making them an unfair deal for many market participants while simultaneously making it a good deal for a select few.

• False Sense of Security: Also, the credit derivatives market is completely unregulated. This creates an ironic situation wherein the organizations selling protection against defaults are not well capitalized themselves and are likely to default in case an adverse event does take place. This is very dangerous since not only the firms not capitalized themselves, they are also creating a false sense of security amongst others. This is creating a situation wherein the other firms are also taking excessive risks because they have a false sense of security. These problems have come to the forefront after the 2008 crisis. The system was working fine until no one defaulted. However, the defaults have exposed shortcomings many of which have already been eliminated.

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.