Credit derivatives offer banks an opportunity to improve the risk/return profile of their loan portfolios, though these new products still need their valuation methodologies refined.
At present, commercial banks and investment/securities houses are the main players in this market, both selling and purchasing protection policies.
The Basics
Credit derivatives allow financial institutions to diversify their exposure to various credit risks. As these products are relatively new and face numerous questions and challenges related to valuation methods and regulatory recognition thereof. Furthermore, questions related to netting TRS with loan portfolio positions and capital charge treatment continue to arise, though their resolution will likely lag behind developments in product design.
Credit derivatives provide banks with an effective risk management tool to move credit exposures off balance sheet without taking on the burden of owning loans and bonds, thus freeing up cash for other purposes and decreasing concentration. They’re also great tools for financing leveraged mergers and acquisitions by helping lenders manage funding exposure associated with these deals.
Risk Management
Credit derivatives give financial institutions the power to adjust their exposure to various credit risks without needing to buy or sell bonds or loans directly.
The market has also developed several instruments to streamline trading procedures. Credit indices such as CDX NA IG and iTraxx Europe provide standardized ways of measuring default probabilities across market segments; and credit-linked notes enable dealers to engineer synthetic positions which would otherwise be difficult or expensive to create in cash markets.
Banks use credit derivatives not only to protect their existing loan portfolios but also as M&A transactions to ease lending constraints. Unfortunately, however, many of the rules governing these trades have not been fully clarified and dealers face a challenge of accurately and precisely calculating expected losses for CDO tranches – historically this market used base correlations as its measure; now however, expected losses are interpolated at each attachment point of structures directly.
Valuation
Lack of uniform documentation on credit derivatives and no widely accepted valuation techniques are major obstacles to market development, compounded further by rapid turnover trades – particularly within multiname markets.
Credit default swaps (CDSs) are one of the most frequently traded financial instruments on this market and can generally be divided into single-name and multiname products. Single-name products provide protection against default of one reference entity while multiname instruments allow investors to transfer risk associated with multiple reference entities at the same time.
Dealers typically protect themselves when dealing with single-name CDS by shorting a company’s bonds or equity, while for multiname contracts they construct portfolios similar to their counterparty’s exposures. Hedging strategies create additional trades which need to be marked to market daily and put additional strain on dealer systems while complicating efforts at coordinating mark-to-market calculations across groups within a firm.
Settlement
Credit derivatives provide financial institutions with a way of diversifying their risk exposure across a wide array of credit risks. These privately negotiated bilateral contracts allow buyers and sellers to meet their respective objectives without actually purchasing bonds or loans directly from each other.
One key market challenge involves developing valuation techniques that are accurate, transparent and consistent across all the instruments being traded. This can be challenging given that many of those creating and trading these instruments often have an vested interest in supporting their growth without providing objective, independent assessments of these markets.
As well as these obstacles, firms also face regulatory obstacles when allocating capital charges across risk positions of their firm. Regulators usually set rules mandating specific amounts of capital per position. Unfortunately, this allocation method often differs according to instrument and makes it hard to apply standard capital charge treatments from spread options or asset swaps to explicit credit derivatives consistently.
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