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Credit Derivatives: An Overview

We have focused on the sales of interest rate hedging products since 2001, but the greatest volumes were sold in the period 2005-2008, before the base rate fell sharply to its current, sustained, historic low. During this period, some banks reduced the minimum loan value against which they were willing to offer interest rate hedging products, widening the target market of customers. A number of customers have complained, directly to us, through their MPs and the media, that they were mis-sold interest rate hedging products by the major retail banks. Many complainants indicated that they believed they were purchasing hedges with. | FEDERAL RESERVE BANK OF ATLANTA Credit Derivatives An Overview DAVID MENGLE The author is the head of research at the International Swaps and Derivatives Association. This paper was presented at the Atlanta Fed s 2007Financial Markets Conference Credit Derivatives Where s the Risk held May 14-16. A derivative is a bilateral agreement that shifts risk from one party to another its value is derived from the value of an underlying price rate index or financial instrument. A credit derivative is an agreement designed explicitly to shift credit risk between the parties its value is derived from the credit performance of one or more corporations sovereign entities or debt obligations. Credit derivatives arose in response to demand by financial institutions mainly banks for a means of hedging and diversifying credit risks similar to those already used for interest rate and currency risks. But credit derivatives also have grown in response to demands for low-cost means of taking on credit exposure. The result has been that credit has gradually changed from an illiquid risk that was not considered suitable for trading to a risk that can be traded much the same as others. This paper begins with a description of credit default swaps total return swaps and asset swaps and then focuses on the mechanics and risks of credit default swaps. The paper then describes the market for credit default swaps and how it evolved and provides an overview of pricing and the risk-management role of the dealer. Next the discussion considers the costs and benefits of credit derivatives and outlines some recent policy issues. The conclusion considers the possible future direction of the market. How Credit Derivatives Work The vast majority of credit derivatives take the form of the credit default swap CDS which is a contractual agreement to transfer the default risk of one or more reference entities from one party to the other Figure 1 . One party the protection buyer pays a periodic fee to the .