CHAPTER 5 Derivatives

  Learning  objectives  

After studying this chapter, you should be able to:

  1. Understand the use of derivatives for hedging interest rate and foreign exchange risks.
  2. Describe the various credit derivative products of interest to bank treasury desks, including credit default swaps, total return swaps, and credit-linked notes.
  3. Explain what collateralised debt obligations are, their role in arbitrage, and how they help in balance sheet management.
  4. Understand how derivatives are priced and the various accounting principles that go into their valuation along with hedging techniques and risk considerations.

Introduction

Before the advent of credit derivatives, there was no instrument available that could be used to hedge credit risk in isolation. This changed during the 1990s. Credit derivatives, and structured credit products that incorporate credit derivatives in their construction, have transformed the way that credit risk can be managed and are a significant development in banking.

The importance of credit derivatives lies in the potential they generate for greater transparency and disintermediation for the market as a whole and transparency with regard to asset valuation, liquidity, and accessibility. The isolation of credit as an asset class, which has resulted in the creation of credit derivatives, is meant to create greater transparency in evaluating fair value, and increased opportunity to speculate and hedge in credit.

As with any complex financial ...

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