Credit Derivatives: New Financial Instruments for Controlling Credit Risk

by Robert S. Neal of the Federal Reserve Bank of Kansas City

Q2 1996

Introduction: One of the risks of making a bank loan or investing in a debt security is credit risk, the risk of borrower default. In response to this potential problem, new financial instruments called credit derivatives have been developed in the past few years.  Credit derivatives can help banks, financial companies, and investors manage the credit risk of their investments by insuring 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 credit derivative.  Thus, if used properly, credit derivatives can reduce an investor's overall credit risk.

Estimates from industry sources suggest the credit derivatives market has grown from virtually nothing two years ago to about $20 billion of transactions in 1995.  This growth has been driven by the ability of credit derivatives to provide valuable new methods for managing credit risk.  As with other customized derivative products, however, credit derivatives expose their users to risks and regulatory uncertainty.  Controlling these risks is likely to be an important factor in the future development of the credit derivatives market.

This article provides information on the rationale 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 how credit derivatives can help manage credit risk.  The third section examines the risks and regulatory issues associated with credit derivatives.

Published in: Federal Reserve Bank of Kansas City, Economic Review, (Q2 1996), pp. 15-27.

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