Credit Derivatives

(Moorad Choudhry, 2004) Theoretically, credit derivatives make a new class of assets made to trade default risk on a range of maturity without a collateral constraint. However, the potential efficiency benefits of credit derivatives are being reduced by lack of liquidity globally, the repo market use in hedging and the lack of secondary markets. The pricing of these instruments is affected by factors such as the option to deliver the cheapest bond and liquidity. In addition, emanating from lack of arbitrage, the rate of repo and bond over libor spread can be utilizedd to price the default swap. (Romain G Ranciere, 2002) In relatively short time, the credit derivative markets have grown, becoming a key component of capital markets and embracing a wide range of participants. They form an important part of the corporate bond market used for hedging and speculative purposes. Credit derivatives are ‘over the counter’ (OTC) instruments and therefore, very flexible. they can be specifically made to suit individual needs and can be used for a wide range of applications. These OTC instruments have a number of advantages such as their ability to be tailor made to suit specific requirements, their ability to isolate the underlying loan or bond from certain aspects of credit risk and their ability to be used by the banks in business restructuring as they allow these banks to parcel out credit risk while retrieving assets on the balance sheet. The three most common credit derivative instruments are credit default swaps, total return swaps, and credit-linked notes. The credit derivatives market share in the corporate sector is estimated at 80 percent and is essentially made up of high yield fixed income market in developed economies. Ironically, the credit derivatives upon upcoming sovereign bonds form the remaining 20 percent. (Moorad choudhry, 2004) BRIEF HISTORY OF CREDIT DERIVATIVES. Although since 1975 credit instruments were operating, it is in the year 1996 that credit derivative markets really started. This came from financial institutions’ held concern about credit risk exposure regarding them. At that moment, the credit derivatives markets started being viewed as a compliment to the loan securitization markets. Quickly, the credit derivatives’ markets developed solely and simply became an important place to hedge as well as take credit risks on sovereign and corporate debts alike. During the crisis in Asia, from july of 1997, the emerging credit markets made a break in forward surge. The markets were slowed down by the absence of standardized documentation until 1999, when the International Swap and Derivatives Association (SDA) credit derivatives definitions were published, though. In year 1998, during which year the Russian nation bond defaults started. Credit derivatives markets were again triggered although some legal documentation problems were highlighted. However, the 1999 ISDA definitions reduced the causes of legal disputes. It is during that period of time that the year 1999 Ecuador-quasi voluntary bond exchange was put under recognition as a credit event. It is also at some time later that the investment markets agreed that the 2000 Argentina debt swap did not constitute a credit event. The Argentina turmoil of 2001