This article, written in April 2007 explored the rapid growth of credit derivatives. Little did we know the damage these products would unleash!
Credit derivatives continue to transform the credit world and open up new dimensions for fund managers, banks and speculators. Jonathan Shapiro reports.
It has been over a decade since the wonder-kids of JPMorgan dreamt up the notion of credit derivatives.
A group within the bank’s global derivatives department assembled in Boca Raton to brainstorm the next big thing in their field.
High on the agenda was the idea of creating securities to insure against the risk of a credit default. For the bank, it would allow them to manage the risk of its portfolio of loans and bonds, and for investors, if the price was right, it provided a healthy return.
Today the global market for credit derivatives is worth over US$26 trillion and still growing at breakneck pace. ‘‘The recent global growth in CDS has been dramatic with CDS outstandings now dwarfing bonds,” said Chris Viol, head of credit analysis, Citigroup.
The CDS universe
The most common form of credit derivatives is a credit default swap. A CDS is quite simply an insurance contract whereby one party - ‘a buyer of protection’ agrees pay another party - ‘a seller of protection’ a premium in exchange for cover if a borrower defaults on a debt obligation.
In many respects, a CDS resembles a bond exposure; the seller of protection who receives the premium is ‘long’ the credit while the buyer of protection, who pays the premium is ‘short’ the credit.
The price of a CDS is quoted by a basis point spread, which just like a bond spread widens as the credit is perceived to weaken and tighten as it strengthens. If a company’s credit worsens the CDS spread which reflects the price of insurance will rise and will increase the value of an existing contract. If the credit improves, the price of insurance will decrease and the value of an existing contract will fall.
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