CAIA Level I: An Introduction to Core Topics in Alternative Investments, 2nd Edition

CHAPTER 24

Credit Derivatives

The risk of fluctuations in the value of assets in an economy is borne by both equity holders and debt holders. The portion of the risk borne by equity holders is often termed market risk, and the portion held by bond holders is termed credit risk. The bearing of risk by both equity holders and bond holders is a vital part of economic activity.

24.1 CREDIT DERIVATIVE MARKETS

Derivatives are cost-effective vehicles for the transfer of risk. Credit derivatives transfer credit risk from one party to another such that both parties view themselves as having an improved position as a result of the derivative. The primary way that credit derivatives contribute to the economy and its participants is by facilitating diversification. Credit derivatives can provide liquidity to the market in times of credit stress. The availability and use of credit derivatives has soared in recent decades, with the result that credit risk has gradually changed from an illiquid risk that was not considered suitable for trading to a risk that can be traded like other sources of risk (e.g., equity, interest rates, and currencies).

Consider the challenge faced by a major bank that has established a long-term relationship with a client such as a traditional operating firm. The bank provides for several of its client's needs, including payment services and credit. If the firm is very large, the credit risk exposure of the bank to the firm through its loans to the firm may become ...