Credit risk is arguably the most significant form of risk capital market participants face. It is often unmanaged, or at best poorly managed, and not well understood. It tends to be situation-specific, and it does not easily fit to the concept of modern portfolio theory. And yet, it is an important consideration in most business and financial transactions. Managing credit risk exposure more effectively is crucial to improving capital market liquidity and efficiency.
Credit derivatives have emerged in the 1990s as a useful risk management tool. They allow market participants to separate credit risk from the other types of risk and to manage their credit risk exposure by selectively transfer-ring unwanted credit risk to others. This distinguishing of credit risk from other types of risk creates new opportunities for both hedging and investing.
Introduced in 1991, the volume of outstanding credit derivatives now exceeds $100 billion notional amount by some estimates. Their use continues to expand, and the participants in this market now include banks, industrial corporations, hedge funds, insurance companies, mutual funds, and pension funds.
Credit derivatives have the potential to alter fundamentally the way credit risk is originated, priced, and managed; they permit investors to diversify their credit risk exposure; and they enable the credit markets to reallocate credit risk exposures to those market participants who are best equipped to handle them. But as credit derivative use has grown, so has concern about whether users really understand the risks involved and whether these instruments are fairly priced. Our paper will try to explains how credit derivatives work and how companies and investors can use them to manage their exposure to credit risk more ef ...