Encyclopedia of Financial Models I

Credit Derivatives and Hedging Credit Risk

DONALD R. VAN DEVENTER, PhD

Chairman and Chief Executive Officer, Kamakura Corporation

Abstract: The credit crisis of 2007–2009 in the United States and Europe and the collapse of the Japanese bubble in the 1990–2002 period show that, without hedging credit risk, the largest financial institutions in the world are very likely to fail. Many trillions of dollars of taxpayer bailouts have put the credit quality of the United States and Japan at risk. The solution to this financial institutions’ risk management problem and the related sovereign risk problem is hedging with respect to macro factor movements. Hedging interest rate movements has a 40-year history, but now the focus has turned to a longer list of macro factors like home prices, commercial real estate prices, oil prices, commodity prices, foreign exchange rates, and stock indices. This hedging capability is now widely available in best practice enterprise risk management software. Stress testing with respect to macro factors is now a mandatory requirement of the European Central Bank and U.S. bank regulators.

In this entry, we examine practical tools for hedging credit risk at both the transaction level and the portfolio level, focusing on the interaction between the credit modeling technologies and traded instruments that would allow one to mitigate credit risk. We start with a discussion linking credit modeling and credit portfolio management in a practical way. We then ...