Arising from financial institutions' need to hedge and diversify credit risk, credit derivatives have now become a major investment tool. Almost all credit derivatives take the form of the credit default swap, which transfers default risk from one party to another. Most credit default swaps were once written on single names, but since 2004 the major impetus to growth and market liquidity has been credit default swaps on indexes.
This paper examines the mechanics, risks, and market for credit default swaps, provides an overview of pricing and dealers' risk-management role, discusses the costs and benefits of credit derivatives, and outlines some recent policy issues.
The author notes that, in the early years of credit derivatives, the major challenges facing these instruments involved resolving ambiguities in reference entities and defining credit events. Since the introduction of index trading and the widespread entry of hedge funds, however, the challenges have been settlement after credit events and addressing operational backlogs stemming from an increase in novations. Now that hedge funds are an established part of the market, the next important issue is likely to be whether credit derivatives activity will move to exchanges.