Credit derivatives

Bonds and loan investors run a high credit risk; the risk that the issuer of the bond or credit might default payment. This seeks for investors’ hedging against the risk by way of utilization of credit derivatives.

Credit derivativesis an expression describing the financial instruments used to protect investors against losses that arise from defaults. These instruments were at first introduced to banks and later to other financial institutions. Over time, these derivatives have been applied by corporate portfolio managers, treasurers, and financial institutions for hedging against to trade credit, risk, for purposes of enhancing speculation and to enhance realization of returns. (Moorad Choudhry, 2004)

Theoretically, credit derivatives make a new class of assets made to trade default risk on a range of maturity without a collateral constraint. However, the potential efficiency benefits of credit derivatives are being reduced by lack of liquidity globally, the repo market use in hedging and the lack of secondary markets.

The pricing of these instruments is affected by factors such as the option to deliver the cheapest bond and liquidity. In addition, emanating from lack of arbitrage, the rate of repo and bond over libor spread can be utilizedd to price the default swap. (Romain G Ranciere, 2002)

In relatively short time, the credit derivative markets have grown, becoming a key component of capital markets and embracing a wide range of participants. They form an important part of the corporate bond market used for hedging and speculative purposes. Credit derivatives are ‘over the counter’ (OTC) instruments and therefore, very flexible; they can be specifically made to suit individual needs and can be used for a wide range of applications.

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These OTC instruments have a number of advantages such as their ability to be tailor made to suit specific requirements, their ability to isolate the underlying loan or bond from certain aspects of credit risk and their ability to be used by the banks in business restructuring as they allow these banks to parcel out credit risk while retrieving assets on the balance sheet.

The three most common credit derivative instruments are credit default swaps, total return swaps, and credit-linked notes.

The credit derivatives market share in the corporate sector is estimated at 80 percent and is essentially made up of high yield fixed income market in developed economies. Ironically, the credit derivatives upon upcoming sovereign bonds form the remaining 20 percent.  (Moorad choudhry, 2004)

BRIEF HISTORY OF CREDIT DERIVATIVES

Although since 1975 credit instruments were operating, it is in the year 1996 that credit derivative markets really started. This came from financial institutions’ held concern about credit risk exposure regarding them. At that moment, the credit derivatives markets started being viewed as a compliment to the loan securitization markets. Quickly, the credit derivatives’ markets developed solely and simply became an important place to hedge as well as take credit risks on sovereign and corporate debts alike.

During the crisis in Asia, from july of 1997, the emerging credit markets made a break in forward surge. The markets were slowed down by the absence of standardized documentation until 1999, when the International Swap and Derivatives Association (SDA) credit derivatives definitions were published, though. In year 1998, during which year the Russian nation bond defaults started. Credit derivatives markets were again triggered although some legal documentation problems were highlighted. However, the 1999 ISDA definitions reduced the causes of legal disputes. It is during that period of time that the year 1999 Ecuador-quasi voluntary bond exchange was put under recognition as a credit event. It is also at some time later that the investment markets agreed that the 2000 Argentina debt swap did not constitute a credit event.

The Argentina turmoil of 2001 reduced the upward progress activity of the credit derivatives market although at the time the markets recorded a volume of one hundred million US dollar. (Romain G Ranciere, 2002)

In 2002, the rise of distributed computing as well as the introduction of internet made mathematics easier and enabled structure credit to be done from anywhere. This led to rise of hedge funds to a volume of up to four trillion US dollar indicating a tremendous expansion to the credit derivatives markets.

Systematic risk became more apparent in 2003 as the collaterized debt obligation market expanded. In 2005, credit derivatives markets became an extremely lucrative business for major brokers and specialty fund managers.

To date, hedge fund counter party remains, making credit derivatives markets a growing market. (www.financial-edu.com)

The table above shows the growth of credit derivatives (in USD billions) trading in markets from 1997-2002.

IMPACT PLAYED BY CREDIT DERIVATIVES MARKETS IN FINANCIAL MELT DOWN OF 2007-2008 YEARS

The global financial systems underwent a period of major unprecedented instability in the year 2007-2008. There being credit derivatives financial markets made the difference occurring between this particular financial crisis and the other financial crisis that happened previously. According to international credit regulators, the credit derivatives amplified the financial crisis by offering an unobstructed direct mechanism for channelling defaults in financial institutions. From an empirical point of view, the transmission of shocks between credit derivatives markets and banks were not well understood which made it hard to make conclusions on the financial stability implications of credit derivatives markets.

The financial crisis was further worsened by the inadequate underwriting procedures in the mortgage markets and the excessive granting of loans by entities not regulated and the financial innovations based on credit market derivatives.

During this period, risk speculators who wanted exposure to certain classes of assets, bonds and loan had a means of speculating them by use of credit derivative markets even though they were not in a financial position of servicing them.

Banks, financial institutions and insurance companies such as AIG, one of the world’s biggest insurance companies, submerged themselves into issuing of loans and bonds based on hedge funds that were overrated and ended up falling tremendously in value as the foreclosures mounted and the number of defaulters rose.

In conclusion, although there were other causes of the 2007-2008 global financial crisis, credit derivatives markets played a major role and were the most significant contributors of the historical financial meltdown of 2007-2008. (www.fdic.gov)