Credit Derivatives and Risk Management

Michael S. Gibson
Economic Review, Vol. 92, No. 4, 2007

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The striking growth of credit derivatives suggests that market participants find them to be useful tools for risk management. This paper illustrates credit derivatives' value with three examples: a commercial bank using credit derivatives to manage loan portfolio risk; an investment bank using them to manage the risks of underwriting securities; and an investor, such as an insurance company, asset manager, or hedge fund, using them to align credit risk exposure with a desired credit risk profile.

But credit derivatives pose risk-management challenges of their own; the author discusses five of these challenges. Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. They can create counterparty credit risk that itself must be managed. Complex credit derivatives rely on complex models, leading to model risk. Credit rating agencies interpret this complexity for investors, but their ratings can be misunderstood, creating rating agency risk. And the settlement of a credit derivative contract following a default can have its own complications, creating settlement risk. For the credit derivatives market to continue its rapid growth, market participants must find ways to meet these risk-management challenges.

December 2007