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Financial Engineering: The Evolution of a Profession by Cara M. Marshall, Tanya Beder

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Chapter 9

Credit Markets

Frank Iacono

Riverside Risk Advisors LLC*

Credit Market Snapshot

History: The largest components of the credit derivatives market today are the credit default swaps (CDS) and the closely related synthetic collateralized debt obligations (CDOs). Many assume that the credit derivatives market began with the introduction of CDS in the mid 1990s, but earlier, predecessor products, including letters of credit, bond insurance policies, and certain types of total return swaps had existed for some time and serve many of the same purposes. Nevertheless, the advent of CDS was a watershed event. The earliest CDS allowed commercial banks to transfer the credit risk associated with their loan portfolios to third parties. By the early 2000s, the CDS market was expanding rapidly, driven in large part by standardization, advances in computational power, and evolved thinking on the management of credit risk. During the past decade, CDS have been used to create several varieties of structured products, to arbitrage capital market inefficiencies, and to both hedge and speculate on corporate, municipal, and government fiscal health. They were also used to create exposure to the mortgage market and to protect holders of mortgage-backed securities. CDS became the focus of considerable interest with the onset of the credit crisis of 2007–2009.

Size: Prior to 2004, the market was of trivial size in comparison to the markets for other types of derivatives. But from a size of ...

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