Credit derivatives - CDS & CDO

Abstract

Until recently, credit risk was one of the major components of business risk for which no tailored risk-management products existed. Credit risk management for the loan portfolio manager meant a strategy of portfolio diversification backed by line limits, with an occasional sale of positions in the secondary market. Derivative users traditionally relied on purchasing insurance, letters of credit, or guarantees, or negotiating collateralized mark- to-market credit enhancement provisions1. Companies either carried open positions on key customers’ accounts receivables or resorted to means such as factoring or forfaiting. However, these strategies were largely inefficient because they do not separate the management of credit risk from the asset with which that risk is associated. For example, a corporate bond, which represents a bundle of risks including duration, convexity, callability, and credit risk (both the risk of default and volatility in credit spreads). If the only way to adjust credit risk is to buy or sell that bond, affecting the positioning across the entire bundle of risks, there is a clear inefficiency. It is with this background that Credit Derivative products have proved to be a significant innovation in the management of both types of credit risk.