ABSTRACT
Credit derivatives, a recent innovation in the credit risk market, can help investors with these issues. Credit derivatives are financial contracts that transfer the (credit) risk and return of an underlying asset from one counterparty to another without actually transferring the underlying asset. The credit derivatives market is growing rapidly and in June 2004 notional amounts for credit derivatives amounted to $4.5 trillion, compared to $0.7 trillion 3 years earlier (BIS 2004). Furthermore, the fact that global markets have much larger exposures to credit risk than to interest rate or currency risk indicates an almost unlimited growth potential for the credit derivatives market.*
Contracts similar to credit derivatives, such as letters of credit and credit guarantees, have been around for centuries, but credit derivatives are different in the sense that they are traded separately from the underlying assets; in contrast, the earlier arrangements were contracts between an issuer and a guarantor. Credit derivatives are therefore ideal risk reduction tools for any investor who wants to reduce the exposure to a particular counterparty but finds it costly to sell outright the claims on that counterparty. A related feature of credit derivatives is that credit risk is transferred without any funding actually changing hands. Only in case a credit event occurs does the buyer of credit risk provide funds ex post to the seller. This way of allowing financial institutions to manage credit risk separately from funding is an example of how modern financial markets divide financial claims into various building blocks (credit, interest rate, exchange rate, etc.) that each can be traded in a standardized wholesale market that better meets the needs of investors.
