Credit Derivatives -CLN

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Credit Derivatives:

New Financial Instrumentsfor Controlling Credit Risk

By Robert S. Neal

One of the risks of making a bank loan orinvesting in a debt security is credit risk,the risk of borrower default. In response

to this potential problem, new financial instru-ments called credit derivatives have been devel-oped in the past few years. Credit derivatives canhelp banks, financial companies, and investors

manage the credit risk of their investments byinsuring against adverse movements in the credit

quality of the borrower. If a borrower defaults,the investor will suffer losses on the investment,but the losses can be offset by gains from the creditderivative. Thus, if used properly, credit deriva-tives can reduce an investors overall credit risk.

Estimates from industry sources suggest the

credit derivatives market has grown from virtu-ally nothing two years ago to about $20 billionof transactions in 1995. This growth has beendriven by the ability of credit derivatives toprovide valuable new methods for managing

credit risk. As with other customized derivativeproducts, however, credit derivatives expose their

users to risks and regulatory uncertainty. Con-trolling these risks is likely to be an importantfactor in the future development of the creditderivatives market.

This article provides information on the ration-ale and use of credit derivatives. The first section

of the article describes how to measure credit risk,whom it affects, and the traditional strategies

used to manage it. The second section shows howcredit derivatives can help manage credit risk.The third section examines the risks and regula-tory issues associated with credit derivatives.

CREDIT RISK

Credit risk is important to banks, bond issuers,and bond investors. If a firm defaults, neitherbanks nor investors will receive their promisedpayments. While there are a variety of methods formanaging credit risk, these methods are typically

insufficient to reduce credit risk to desired levels.This section defines credit risk, describes how it canbe measured, and shows how it affects bond

issuers, bond investors, and banks. The sectionalso describes the techniques most commonly usedto manage credit risk, such as loan underwritingstandards, diversification, and asset securitization.

Robert S. Neal i s an economist at the Federal Re serve Bank of

Kansas City. Douglas S . Rolph, a re search associate at the bank,

helped prepare the article.


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What is credit risk?

Credit risk is the probability that a borrowerwill default on a commitment to repay debt or

bank loans. Default occurs when the borrowercannot fulfill key financial obligations, such asmaking interest payments to bondholders orrepaying bank loans. In the event of default,lendersbondholders or bankssuffer a loss be-cause they will not receive all the paymentspromised to them.1

Credit risk is influenced by both business cyclesand firm-specific events. Credit risk typically

declines during economic expansions becausestrong earnings keep overall default rates low.Credit risk increases during economic contrac-tions because earnings deteriorate, making itmore difficult to repay loans or make bondpayments. Firm-specific credit risk is unrelated to

business cycles. This risk arises from events spe-cific to a firms business activities or its industry,events such as product liability lawsuits. Forexample, when the health hazards of asbestosbecame known, liability lawsuits forced Johns-Manville, a leading asbestos producer, into bank-

ruptcy and to default on its bonds.

A broad measure of a firms credit risk is its creditrating. This measure is useful for categorizingcompanies according to their credit risk. Ratingfirms, such as Moodys Investors Services, assigna credit rating to a company based on an analysisof the companys financial statements. Creditratings range from Aaa for firms of the highestcredit quality, to Ccc for firms likely to default.2

A more quantitative measure of credit risk isthe credit risk premium. The credit risk premiumis the difference between the interest rate a firmpays when it borrows and the interest rate on adefault-free security, such as a U.S. Treasury bond.The premium is the extra compensation the bondmarket or commercial bank requires for lending

to a company that might default. As a firmscredit risk increases, bond investors and com-mercial banks demand a higher credit risk pre-mium. This increase is necessary to offset the

higher expected losses on the bond or loan dueto the increased probability that the loan will notbe repaid.

The characteristics of credit risk premiums aredisplayed in Chart 1. The chart shows the riskpremiums for Aaa and Baa industrial bonds from1984 to 1994. The top line is the interest rate for

all Baa-rated bonds less the interest rate for10-year Treasury bonds, while the bottom line

shows the rate for Aaa bonds less the 10-yearTreasury rate. There is a strong relation betweenthe credit rating and the credit risk premiumthehigher the credit rating, the lower the credit riskpremium. As a result, a downgrade in a com-panys credit rating can significantly increase its

borrowing costs. The chart also shows that thecost of borrowing for a company with a constantrating can vary over time. For example, the Baapremium increased from 1.4 percent in August1981 to 3.0 percent in November 1981.

Who is affected by credit risk?

Credit risk affects any party making or receiv-ing a loan or a debt payment. Some examplesinclude bond issuers, bond investors, and com-mercial banks.

Bond issuers. Bond issuers are affected by creditrisk because their cost of borrowing dependscrucially on their risk of default. A borrower whoplans to issue debt in the near future faces the

risk that unanticipated events will suddenly in-crease the costs of borrowing. For example, therecent disclosure of a $1.1 billion trading loss atDaiwa Bank raised fears of the banks default,which increased its cost of borrowing.3 Moreover,even without a change in a companys firm-specificcredit risk, a downturn in the economy could

16 FEDERAL RESERVE BANK OF KANSAS CITY


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raise the average credit risk premium and increasethe cost of borrowing for all bond issuers.

Bond investors. Investors in individual bonds

are exposed to the risk of a decline in the bondscredit rating. A downgrade in a credit rating willincrease the bonds credit risk premium andreduce the value of the bond. Similarly, mutualfunds that hold a portfolio of corporate bondswill be affected by fluctuations in the averagecredit risk premium. Increases in the premiumwill reduce the value of the funds holdings and

hurt the funds total return.

Commercial banks. Banks are exposed to the riskthat borrowers will default on their loans. The

credit risk faced by banks is relatively high fortwo reasons. First, banks tend to concentrate theirloans geographically or in particular industries,which limits their ability to diversify credit risks

across borrowers. Second, credit risk is the pre-dominate risk in loans made to businesses. Mostbusiness loans have adjustable rates, with theinterest rate periodically reset to reflect changesin the default-free rate. Since these loans incorpo-rate changes in the default-free rate, movementsin the default-free rate pose little risk to banks.The credit risk premium, however, is fixed when

the loan is made. If the premium subsequentlyrises, lenders will suffer because the loan pay-ments are insufficient to compensate for thehigher risk.

Baa

Note: The Baa credit risk premium is the average rate on Baa corporate bonds less the 10-year Treasury bond rate. The Aaa

credit risk premium is the average rate on Aaa corporate bonds less the 10-year Treasury bond rate.

Source: Moodys Investors Service and Board of Governors.

CREDIT RISK PREMIUM FOR BONDS

Chart 1

1982 1984 1986 1988 1992 199419901980

Percent

4

3

2

-1

5

0

1

Aaa

ECONOMIC REVIEW SECOND QUARTER 1996 17


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How is credit risk managed?

A variety of methods are available to managecredit risk. Traditional methods have focused on

loan underwriting standards and diversification.Over the last ten years, an alternative approachto managing credit risk has focused on sellingassets with credit risk. Banks can sell their loansdirectly or they can securitize, or pool togethertheir assets with credit risk and sell parts of thepool to outside investors. Either way reducescredit risk because the credit exposure is trans-

ferred to the new owner. Unfortunately, thesemethods are insufficient for managing the credit

exposure of many financial firms.

Underwriting standards and diversification. Thetraditional approach to managing credit risk isbased on the application of underwriting stand-ards and diversification. For example, take a bank

loan officer who is deciding whether to make aloan. After a careful review of the prospectiveborrowers financial statements, the officerwould consider such factors as earnings, profitmargins, and the amount of outstanding debtand bank loans. If the prospects for the loan look

good, the loan officer then considers the condi-tion of the borrowers industry by examining

competitive pressures, product cycles, and futuregrowth prospects. Upon a favorable review, thebank loan officer would manage the credit riskexposure by controlling the terms of the loan.The officer would set limits on the size of theloan, establish a repayment schedule, and requireadditional collateral for higher risk loans. Amutual fund that invests in corporate bonds goesthrough a similar credit analysis, although it

cannot set the terms of the borrowing.

The next step in the traditional approach is todiversify the credit risks across different borrow-ers. The diversification principle relies on offset-ting risks. For example, consider the earnings oftwo park vendors, one who sells ice cream and

another who sells umbrellas. On sunny days, theice cream vendor does well, while the umbrellavendor does poorly. On rainy days, the umbrellavendor does well, while the ice cream vendor does

poorly. Although the individual earnings of thetwo vendors can be quite volatile, the combinedearnings are much less volatile due to the negativerelation between their earnings.4 The same prin-ciple holds for a portfolio of bank loans. Thefactors that cause industrial companies to defaulton their loans will differ from the factors thatcause farmers to default on their loans. Relative

to holding either type of loan separately, combin-ing both types of loans into a portfolio allows

the bank to reduce the volatility of its earnings.5

The earnings from some loans will offset thelosses from defaulted loans, thereby reducing thelikelihood that, on net, the bank will lose money.

While diversification and underwriting stand-

ards are necessary first steps for managing creditrisk, their ability to reduce credit risk is oftenlimited by a scarcity of diversification opportu-nities. For example, because small commercialbanks typically confine their lending to theirlocal area, the lack of geographic diversification

means the earnings from their loans will dependheavily on the condition of the local economy.

Similarly, the finance divisions of automobilecompanies face limited diversification opportu-nities. While a finance division can diversifysome credit risk by lending to different dealers,cyclical movements in the economy will affect alldealers, thereby limiting the opportunities fordiversification.

Securitization and loan sales. In recent years, the

development of markets for securitized assets andfor loan sales has provided another method formanaging credit risk. In the asset securitizationapproach, bonds or loans with credit risk arepooled together and sold to an outside investor.For example, the finance division of an automo-tive company can combine many of its loans into



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a single package and sell pieces of the package toother financial institutions. From an investorsperspective, purchasing part of the package isattractive because the diversification across many

loans reduces the overall credit risk. In addition,to the extent that returns from the package arenot closely correlated with the investors otherholdings, diversification allows the investor toreduce the credit risk of his overall portfolio.From the automobile companys perspective, sell-ing the loans eliminates the companys creditexposure to the loans. The substantial growth in

the market for non-housing-related securitizedassets is one indication of the success of this

approach for managing credit risk. In 1994, $75billion of such securitized assets were issued, upfrom virtually nothing in 1984.

Banks can use the market for loan sales tomanage their credit risk in a similar manner.

After making a loan to a company, a bank can sellthe loan to other banks or to institutional inves-tors. One common example of a loan sale occurswhen a bank provides short-term financing for acorporate takeover. After making the loan, thebank will quickly sell the loan to other investors.

This strategy is attractive to banks because theyearn a fee from the loan origination but the credit

risk is assumed by the new investor. Occasionally,banks will lend large amounts in a single take-over, so that controlling the credit risk is ex-tremely important. The use of loan sales by banksto manage their credit risk has increased rapidly inthe last few years. In 1994, banks sold $665 billionof loans, up from about $200 billion in 1991.

The markets for securitized assets and loan

sales provide valuable tools for managing creditrisk. Unfortunately, the securitization approachis only well suited for loans that have stand-ardized payment schedules and similar credit riskcharacteristics, such as home mortgages and auto-mobile loans. Loans for commercial and indus-trial purposes, in contrast, have diverse credit

risks. Consequently, it is difficult for banks tosecuritize these loans or sell them to institutionalinvestors. In cases such as these, a more promis-ing way to manage the credit risk is through

credit derivatives.

MANAGING RISK WITH CREDITDERIVATIVES

Credit derivatives are financial contracts thatprovide insurance against credit-related losses.These contracts give investors, debt issuers, and

banks new techniques for managing credit riskthat complement the loan sales and asset securi-

tization methods. This section examines threetypes of popular credit derivativescredit swaps,credit options, and credit-linked notesandshows how they can help manage credit risk.6

Credit swaps

Credit swaps reduce credit risk through diver-sification. Credit swaps are appealing to commer-cial banks whose loan portfolios are concentratedin particular industries or geographic areas. In-stead of diversifying credit risk by lending out-

side its local area or by selling some loans andpurchasing others, a bank can swap the payments

from some of its loans for payments from adifferent institution.

The simplest type of credit swap is called a loanportfolio swap. Take, for example, two hypotheti-cal banks, Kansas Agricultural Bank, which lendsmostly to farmers, and Chicago Industrial Bank,which lends mostly to manufacturers. The swaptransaction between the two banks also involves

an intermediary, St. Louis Risk Management. Toexecute the transaction, Kansas Agricultural Banksends the loan payments it receives from, say, $50million of its agricultural loans to St. Louis RiskManagement (Figure 1). Simultaneously, St.Louis Risk Management receives $50 million ofloan payments from Chicago Industrial Bank. St.



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Louis Risk Management then swaps the loanpayments between the two banks. Since there islittle common movement in default rates betweenfarmers and manufacturers, both banks are betteroff. The swap allows each bank to diversify away

some of its credit risk, and St. Louis Risk Man-agement receives a small fee for arranging thetransaction.

The most common credit swap is called a totalreturn swap. In this type of transaction, Kansas

Agricultural Bank sends its loan payments to St.Louis Risk Management, which, in turn, sendsthe payments to Minneapolis Mutual, a hypo-thetical insurance company (Figure 2). In exchangefor the loan payments, Minneapolis Mutual

sends an adjustable-rate interest payment to St.

Louis Risk Management, which sends the pay-ment to Kansas Agricultural Bank. Based on a$50 million investment, Minneapolis Mutualmight send Kansas Agricultural Bank a return of2 percent greater than the 3-month Treasury billrate. The effect of this swap for Kansas Agricultural

Bank is to trade the return from its loan portfoliofor a guaranteed return that is 2 percent abovethe short-term default-free rate. Because thereturn is guaranteed, Kansas Agricultural Bankhas eliminated the credit risk on $50 million of

its loan portfolio.7

Relative to loan sales, total return swaps offer

two important advantages. First, they allow banksto diversify credit risk while maintaining confi-dentiality of their clients financial records. In atotal return swap transaction, the borrowingfirms records remain with the originating bank.

When loans are sold, the firms records are trans-ferred to the new owner of the loan. Second, theadministrative costs of the swap transaction can

be lower than for a loan sale transaction. For

example, an institution such as an insurancecompany may be ill suited to monitor loans andto ensure that floating rate loans are properlyadjusted for changes in the default-free rate. Thus,reducing administrative expenses allows diversi-fication to be achieved at a lower cost.

LOAN PORTFOLIO SWAP

Figure 1

Payments from Chicago Industrial

Banks $50 million loan portfolio

St. Louis RiskManagement

Payments from Kansas AgriculturalBanks $50 million loan portfolio

KansasAgricultural

ChicagoIndustrial



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Credit options

Credit options are a second type of creditderivative used to hedge the risk of adverse changes

in credit quality. A simple way to understand

credit options is to use an analogy with carinsurance. All car owners pay a fee to purchasecar insurance and protect themselves from finan-cial loss. If the car is undamaged, the car ownerreceives nothing from the insurance company. Ifthe car is wrecked, the insurance company paysthe owner enough to replace the car. Thus, for afee, the insurance policy hedges the value of the car

by eliminating the risk of a large financial loss.

Credit options provide a similar hedging func-tion. These options allow investors to buy insur-

ance to protect themselves against adverse movesin the credit quality of financial assets. For exam-ple, a bond investor might buy an insurancepolicy to hedge the value of a corporate bond. Ifthe bond defaults, the payoff from the insurance

policy would offset the loss from the bond. If

there is no default, the investor would continueto receive the interest payments from the bondbut receive nothing from the policy.

The key features of credit options are identical

to options on stocks. For example, consider a calloption on IBM stock. The owner of the calloption has the right to buy IBM shares at apreviously determined price called a strike price.

When the current price of IBM exceeds the strikeprice, the owner of the call option can earn a profitby purchasing shares of IBM at the strike priceand then selling them at the current market price.

A second type of option is a putoption. Ingeneral, put options are similar to insurancepolicies because they protect investors from

declines in the value of the underlying asset. AnIBM put option, for example, gives the owner ofthe option the right to sell IBM shares at apredetermined strike price. If the market pricefalls below the strike price, the owner of the

option can earn a profit by purchasing IBM

TOTAL RETURN SWAP

Figure 2

Payment equals Treasury bill rate +

2 percent on a $50 million investment

St. Louis RiskManagement

Payments from Kansas AgriculturalBanks $50 million loan portfolio

KansasAgricultural

ChicagoIndustrial



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shares at the market price and selling the shares atthe strike price. A put option, therefore, providesinsurance against a decline in IBMs stock price.

While these examples link the payoff of theoption to the price of the underlying stock,options are also available where the payoff islinked to an interest rate. For example, fixed-ratemortgages typically provide a 30-day interest ratelock. Following approval of the loan, the prospec-tive homeowners mortgage rate is protectedagainst rate increases for 30 days. This interest

rate protection is actually a call option on theinterest rate because the homeowner implicitly

receives a payment if mortgage rates rise follow-ing the loan approval. For example, if the rateincreases by 0.5 percentage point, the homeownerimplicitly pays the increase, but also receives anoffsetting payoff from the call option. Thus, theinterest rate lock offsets any increases in mort-

gage rates, ensuring that the homeowners ratewill not rise.

In a similar manner, bond issuers can use creditoptions to hedge against a rise in the averagecredit risk premium. As a hypothetical example,

suppose Midwest Telephone, a Baa-rated com-pany, is planning to issue $100 million of 1-year

bonds in two months. The bonds are to be paidback in one year, and the interest rate MidwestTelephone anticipates paying is 1.5 percentagepoints above the 1-year Treasury bill rate. If thereis an increase in the average credit risk pre-mium for Baa companies before the debt isissued, Midwests interest payments will also rise.To hedge against this possibility, Midwest couldpurchase a call option on the credit risk pre-

mium.8 Just as a call option protects a home-buyer against a rise in mortgage rates, the calloption on the credit risk premium protects Mid-west against increases in the premium. If thepremium rises above the strike rate specified inthe option, Midwests higher interest paymentswill be offset by gains from the option.

To illustrate this example, say Midwest Tele-phone buys a call option on the average Baacredit risk premium. For the $100 million bond,the price of the option is $500,000. The current

credit risk premium is 1.5 percent and the calloption will pay Midwest if the premium exceeds1.5 percent in two months. Because the strike rateequals the current risk premium, the optionprotects Midwest against an increase in thepremium. If a downturn in overall economicconditions causes the average premium to rise to2.5 percent, the one-percentage-point rise in the

credit risk premium will cause Midwests inter-est payments to increase by $1 million. The

higher interest payments, however, will be offsetby the payoff from the option (1 percent times$100 million, or $1 million). Since the paymentfrom the call option offsets the increasedborrowing costs, purchasing the call optionallows Midwest to hedge against increases in the

premium.9

Alternatively, suppose that the credit risk pre-mium falls to 0.5 percent. In this case, the calloption has no payoff, but Midwest saves $1million (1 percent of $100 million) because it can

borrow at the lower rate. Thus, purchasing thecall option allows Midwest to insure against

increases in the credit risk premium while main-taining the benefits of lower borrowing costs ifthe premium declines. In either case, Midwestwould still pay the $500,000 for the option, justas it would pay a premium for any other insur-ance policy.

Credit options can also be used by bond inves-tors to hedge against a decline in the price of a

bond. Such a decline might be caused by adowngrade in a companys debt. To hedge thisrisk, the investor can purchase an option that hasa large payoff if the credit quality of the bonddeclines. A decline in quality will trigger a losson the bondholdings, but this will be offset bythe gains from the option. This insurance protects



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the investor from adverse movements in a firmscredit quality.10

To illustrate, suppose an investor owns $10

million of a companys bonds. To insure againstan adverse movement in the companys creditquality, the investor might buy a put option onthe bonds with a $9 million strike price for$40,000. This option would give the investor theright to sell his bond holdings for $9 millionanytime during the next year. Purchasing theoption ensures that the investor will get at least

$9 million for the bonds. If the market value ofthe bonds falls to $7 million in one year, the

payoff of the option will be $2 million. Alterna-tively, if the value of the bonds rises to $12million in a year, the value of the put option willfall to zero. Thus, the put option protects theinvestor against price declines while still allowingthe investor to benefit from price increases.

One particularly common form of creditoption is called, somewhat inappropriately, acredit default swap. This swap is actually a putoption on a portfolio of bonds or loans. Theowner of the default swap receives a payoff if

more than a prespecified number of the bondsdefault. For example, suppose an investors port-

folio includes 20 Baa bonds, each of whichpromises to pay $1,000 in one year. The investormight purchase a credit default swap for $20 thatpromises to make a payment if three or more ofthe 20 bonds default. For each bond that defaults,the investor receives the difference between the$1,000 promised payment and the yearend priceof the defaulted bond.11

The appeal of a credit default swap is that itlimits the investors credit risk. It is designed forinvestors who are willing to absorb small creditlosses but want protection against large losses. Inexchange for a relatively small fee, the investor isexposed to the risk that one or two bonds maydefault but is protected against additional losses.

While investors clearly have an incentive topurchase credit options, it is natural to ask whowould agree to sell such options. Industry sourcessuggest that insurance companies are among the

principal sellers. Insurance companies specializein assessing health and property risks and incharging an appropriate fee for insurance. Insur-ing financial risks is a logical extension of theirbusiness. They earn a fee for selling the creditoptions and can diversify their risks by sellingcredit options in different industries and indifferent areas.

Credit-linked notes

A credit-linked note is another type of creditderivative that can be used by debt issuers tohedge against credit risk. A credit-linked note isa combination of a regular bond and a creditoption. Just as with a regular bond, the credit-

linked note promises to make periodic interestpayments and a large lump sum payment whenthe bond matures. The credit option on the note,however, typically allows the issuer to reduce thenotes payments if a key financial variable speci-fied by the note deteriorates.

For example, a credit card company may use

debt to fund a portfolio of credit card loans. Toreduce the credit risk, the companys debt issuecould take the form of a 1-year credit-linked note.This note promises to pay investors $1,000 andan 8 percent coupon if a national index of creditdelinquency rates is below 5 percent. If the indexexceeds 5 percent, however, the coupon falls to 4percent. The credit card company thus has acredit optionthe company has the right to lower

the interest payments if the overall credit qualityof cardholders deteriorates.

A credit card company would issue a credit-linked note because it provides a convenientmechanism to reduce the companys credit expo-sure. If cardholder defaults are low, then the



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company can pay the 8 percent coupon. If thedefault rates are high, the companys earnings arereduced, but it only has to pay a 4 percentcoupon. By structuring the note in this way, the

credit card company is purchasing credit insur-ance from the investors.

Investors would consider buying such a credit-linked note because they earn a higher rate ofreturn than the credit card companys regularbonds. When the company issues the notes, theprice of the notes will be lower than the price of

the companys regular bonds. The lower pricecompensates investors for the risk that their

interest payments could decline. For a giveninterest payment, the reduced price that investorspay gives them a higher return.

CREDIT DERIVATIVES: RISKS ANDREGULATORY ISSUES

While credit derivatives provide a valuable toolfor managing credit risk, they can also expose theuser to new financial risks and regulatory costs.Like other over-the-counter derivative securities,credit derivatives are privately negotiated finan-

cial contracts. These contracts expose the user tooperational risk, counterparty risk, liquidity risk,

and legal risk. In addition, there is uncertaintyregarding the regulatory status of credit deriva-tives and the appropriate capital charges for bankloans hedged with credit derivatives. For the mostpart, these risks are either controllable or rela-tively small and therefore unlikely to restrict thedevelopment of the credit derivatives market.

What are the risks of credit derivatives?

Perhaps the largest risk of using credit deriva-tives is operational risk. Operational risk is therisk that traders could imprudently use any de-rivative instrument for speculation instead ofhedging. For example, losses from unwarrantedderivatives-related trading caused the dissolution

of Barings PLC, a British investment bank, andcontributed to the default of Orange County,California. While operational risk can be large,it can also be controlled easily. Rigorous internal

control procedures, for example, can preventtraders from establishing inappropriate positions.

A second source of risk is counterparty risk.This is the risk that the counterparty to a transac-tion will default. For example, in the total returnswap described earlier, Minneapolis Mutual coulddefault after initiating the swap with Kansas

Agricultural. Because of this possibility, creditderivatives cannot completely eliminate credit

risk.

While counterparty risk is a source of concern,the magnitude of this risk is relatively small. Fora firm to suffer a loss from a counterpartydefault, all the following must occur: the coun-

terparty must default, the counterparty must owemoney on the credit derivative transaction, andthe loss must be greater than can be absorbed bythe intermediary to the transaction. The likeli-hood that the intermediary cannot absorb theloss, however, is very low. The intermediaries are

either top-rated commercial banks or the Aaa-rated subsidiaries of investment banks. Both

types of organizations are well capitalized andcarefully hedge the risk of their transactions(Figlewski).

A third source of risk is liquidity risk. Liquidityrisk is the uncertainty about being able to sell oroffset a previously established position. For firmsholding credit derivatives strictly for hedging,liquidity risk is relatively unimportant. For exam-

ple, consider a bond issuer who uses a creditoption to hedge its future costs of borrowing.Because the option will be structured to expireon the borrowing date, the bond issuer willsimply hold the option until expiration. In con-trast, liquidity risk is an important considerationfor issuers of credit derivatives and for users of



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credit derivatives who anticipate offsetting theirposition before the contract matures. Liquidityrisk is currently high because there is no activesecondary market for participants to hedge their

credit exposure or to offset a previously estab-lished position. To the extent that the marketbecomes more active, this risk will decline.

A fourth source of risk for credit derivativeusers is legal risk. Legal risk is the possibility thata derivative contract may be deemed illegal orunsuitable. The Orange County bankruptcy pro-

vides an example of legal risk. For several years,the County successfully invested in risky, fixed-

income derivative securities. A sudden and largechange in interest rates, however, caused a steepdecline in the value of its securities, leaving theCounty unable to meet margin calls. In the wakeof the bankruptcy, the County sued the invest-ment bank that sold them the securities. The

County claimed it was illegal for it to hold suchsecurities and therefore the derivative securitieswere unenforceable contracts. The issue is cur-rently being resolved in the courts. If the courtsagree with the County, the likelihood will in-crease that losing parties on other derivative

transactions will adopt legal defenses to avoidhonoring their derivative contracts. Such a devel-

opment would strongly restrict growth in thecredit derivatives market.

Regulatory issues

Another uncertainty confronting users ofcredit derivatives is their regulatory status. Shouldcredit derivatives be treated as securities, com-modities, swaps, or insurance products? This

distinction is important because these contractsare regulated by different agencies and underdifferent terms. Swaps, for example, are regulatedby the Commodities Futures Trading Commis-sion. Suppose that a firm enters a credit swapcontract. If the regulatory status changes and thecontract is subsequently regarded as a security, it

would then be under the jurisdiction of theSecurities and Exchange Commission. SinceSEC regulations require additional disclosure,the contract could be considered illegal. A change

in regulatory status could therefore potentiallyinvalidate previously established credit deriva-tive transactions.

Another regulatory issue is capital require-ments for credit derivatives. Banks may find thathedging credit risk actually increases their capitalrequirements. Suppose a bank uses a credit

derivative to construct a long-term hedge for thecredit risk of a large borrower. The credit deriva-

tive reduces the risk of the bank, but undercurrent risk-based capital standards there is norecognition of the lower risk. Not only is thereno reduction in the banks capital requirementfor the loan, but the bank must set asideadditional capital to insure against counterparty

default. As credit derivatives become more avail-able, regulators will need to assess the circum-stances under which credit derivatives can reducea banks capital requirements. If regulators allowprudently structured credit hedges to reduce capi-tal charges, banks will have a strong incentive to

adopt such hedges, which would reduce theircredit risk and allow them to make more loans.

CONCLUSION

Credit risk is an important consideration forbanks, bond issuers, and bond investors. Theconventional methods of managing credit risk,such as diversification, bank loan sales, and assetsecuritization, offer only a partial solution tocontrolling credit risk exposure. In recent years,

the growing market for credit derivatives hasprovided powerful new tools for managing creditrisk that are less costly and more effective thantraditional methods. Lenders such as commercialbanks and investors such as mutual funds can usecredit derivatives to hedge against adverse movesin the credit quality of their investments.



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Despite its recent growth, the market for creditderivatives is still in its infancy. Many observersbelieve that the growth in credit derivatives willparallel the enormously successful interest rate

swap market. For this to occur, however, credit

derivative issuers and users must resolve uncer-tainties associated with regulatory status, legalstatus, and the adequacy of internal control pro-cedures.

ENDNOTES

1 An alternative definition of credit risk relies, not onabsolute default rates, but on the variability of actual defaultrates relative to expected default rates. Suppose a lenderexpects a 20 percent default rate on a portfolio of high-riskloans and sets the int erest rate accordingly. If the subsequentdefault rate is close to 20 percent, it can be argued that the

credit risk of the portfolio is actually low. The lender hasearned a high rate of return on the loans and the uncertaintysurrounding the rate is low. To keep the presentation simple,the article uses the definition in the text. Use of thealternative definition does not change any of the results in

the article.

2 From highest to lowest quality, Moodys ratings are Aaa,Aa, A, Baa, Ba, B, and Ccc. Categories Baa and above aretermed investment-grade bonds, while categories Ba and

lower are termed non-investment-grade, or junk, bonds.

3Two weeks after the disclosure of the trading loss, Standardand Poors downgraded Daiwas bonds. The bond market

reaction to the disclosure was even swifter. The price of

Daiwas bonds fell immediately, suggesting that investorsrequired a higher credit risk premium to compensate for theadditional default risk.

4 Diversification can also reduce volatility even if theearnings of the firms are positively related. All that isrequired for diversification to yield benefits is that theearnings of the two firms not be perfectly positively correlated.

5 Strictly speaking, the gains from diversification areprimarily obtained from reducing firm-specific credit risk.Diversification will yield fewer benefits in reducing creditrisk associated with business cycles because thesefluctuations affect all firms.

6 Whittaker and Kumar provide a more detailed discussionon the uses of credit der ivatives.

7 Strictly speaking, the credit risk has not been eliminatedbecause of the possibility that the counterparty, MinneapolisMutual, may default. Since the counterparties typically have

high credit ratings, however, credit risk is significantlyreduced.

8 Longstaff and Schwartz provide a mathematical model forpricing such options.

9 In this example, the strike price of the option was set to1.5 percent, the same as the level of the Baa credit riskpremium when the option was purchased. In practice, anissuer could purchase an option with a higher strike price.

The advantage of a higher strike price is that the price of theoption is lower. The disadvantage is that it offers lessprotection against an increase in the average credit riskpremium.

10 For a discussion of the methods used to price such options,see the articles by Das and by Jarrow, Lando, and Turnbull.

11 The credit default swap is called a swap because of its

payment structure. Instead of directly paying theintermediary $20 for the option, the bondholder swaps apayment to the intermediary in exchange for the defaultprotection. The payment is expressed as a fraction of thevalue of the total promised payments of the bond portfolio.

In this case, the payments would be $20/$20,000, or 0.1percent. The bondholder would swap 0.1 percent of thepromised payments to the intermediary in exchange for thedefault protection.



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REFERENCES

Das, Sanjiv. 1995. Credit Risk Derivatives, Journal of

Derivatives, Spring, pp. 7-23.

Figlewski, Stephen. 1994. The Birth of the AAA Derivatives

Subsidiary,Journal of Derivatives, Summer, pp. 80-84.Jarrow, Robert, David Lando, and Stuart Turnbull. 1994. A

Markov Model of the Term Structure of Credit Spreads,

working paper, Cornell University.

Longstaff, Francis, and Eduardo Schwartz. 1995. Valuing

Credit Derivatives, Journal of Fixed Income, June, pp. 6-14.

Whittaker, Gregg, and Sumita Kumar. 1995. Credit Deriva-

tives: A Primer, working paper, Chemical Bank, andforthcoming in Ravi Dattateya, ed., The Handbook of Fixed

Income Derivatives. Chicago: Probus Publishing Company.



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Credit Derivatives -CLN