Credit Derivatives for risk management

In recent times the issue of credit risk management has been attracting a great deal of attention globally. Despite various structural developments risk-management practitioners and regulators are still overtly concerned about risk exposure and the issues related to credit default. The issue of the effects of distribution of credit in the economy and how it affects the role of the central banks as the lender of the last resort is vital. Similarly, the use of credit derivatives may reduce the transparency within the financial system regarding allocation of risks and at the same time reduce the effect of money policy transmission. The problem of designing an appropriate regulatory structure are becoming more difficult with derivatives and off-balance sheet items, and are more difficult for developing countries, both because they are likely to face a shortage of good regulators and because they face greater risks Furman and Stiglz (1998). ). In India, for instance, the Central Bank, has issued draft guidelines for banks and dealers to begin trading credit default swaps in the country to mitigate risks emerging due to such trading means.
A vital feature of credit derivative is that they allow for trading and diversification of risk. Credit derivatives allow traders to package the risk inherent in a loan into tradable components. Thus the interest rate risk is isolated via interest rate swaps, the credit risk via credit derivatives and any exchange risk if present is mitigated via foreign exchange derivatives. As the risks can now be shifted to those who are willing to bear them, it will lead to increased allocation efficiency in the economy.In the credit derivatives markets bank and securities brokers-dealers generally serve as the product dealer, acting as the buyer or seller in derivative trading with end users or other dealers.
Credit Derivative Instruments:
Olivier Prato (2002) classifies use of credit derivatives as:
a) Hedging instruments, which allow an institution to hedge its risk on a counter party and at the same time, meet its capital requirements without really affecting its existing commercial interests with the counter party.a) Investment Instruments, which permit a participant to acquire, counter party risk without having to provide funding or enter into a commercial relationship with the counter party.
b) Trading instruments, designed to generate a short-term capital gain over the expected path of credit risk.
Broadly, these instruments can be divided into two categories. Unfunded credit derivatives, which are purely synthetic transactions that incur no financing cost for the protection seller. And funded credit derivatives where the protection seller purchases a security or claim. Unfunded credit derivatives can be further subdivided into four types of instruments:
Credit Default Swaps (CDS)
Credit Spread Options (CSO)
Total Rate of Return (TROR) swaps
First to Default (FTD) swaps
Funded Credit Derivatives:i)Credit Linked Notes (CLN)
ii) Collateralized Debt Obligation (CDO)
Credit derivative market will help to improve financial stability by facilitating the dispersion of credit risks. It allows dispersion of risk to a larger set of investors. As such it insulates the financial institutions and banks from credit shocks or at least help, to reduce the impact of the shock. Concerns have been raised that credit derivatives spreads the risk so wide that it may not always be possible to track them in the financial system. This might affect the ultimate stability, although most evidence as of now point’s against it. It is argue that the ship reduces the quantum of risk for each participant and makes it easier to absorb unless otherwise the participants are over exposed to high-risk instruments. One major area of concern among regulators is the backlog of unconfirmed trades, resulting in part from under investments in the back office capacity by major dealers. In light of these ISDA has proposed streamling of novations (reassigning trades) protocol and the industry has agreed to cooperate. In India Reserve bank of India has proposed to make cash settlement in single name CDS. This should help improve the settlement process. The question of effectiveness of credit risk transfer still exists. ISDA has been tracking outstanding notional amounts of credit derivatives for several years. However notional amounts are not sufficient to measure the economic risk transferred. As discussed earlier delta-adjusted volume is a better way to measure economic risk transfer for portfolio swaps. Regulators have to ensure that recipient of credit risk have the risk management system and skill needed to manage such exposures. In emerging markets like India the issue of institutional shortcomings like bankruptcy codes, creditor rights, clearing and settlement agencies can impede the growth of credit derivative market.
The effect of risk transfer on the monetary policy transmission mechanism is significant as evidenced from research particularly in the US markets. It has been found that it reduces the impact of the monetary transmission effect as the importance of interest rates reduces and the availability of liquidity and credit volumes become determining factors. There is a great deal of uncertainty about how critical variables – including credit aggregates, consumption, fixed investment, and inflation – will behave under the new scenario. Hence further studies on this are vital for policy makers to establish action plan to deal with it.