Unless purchasing what are considered default-free instruments, such as U.S. Treasuries, German bunds, or U.K. gilts, bond investors are exposed to credit risk. This is the risk that the debt issuer will default either on servicing the loan—delaying or failing to make the coupon payments, known as a technical default—or on paying back the principal, an actual default. To hedge this risk, investors may use credit derivatives. These instruments, which were introduced in significant volume only in the mid-1990s, were originally designed to protect banks and other institutions against losses arising from credit events. Today they are used to trade credit and to speculate, as well as for hedging. Gup and Brooks (1993) noted that swaps ’ credit risk, unlike their interest rate risk, could not be hedged. That was true in 1993. The situation changed quickly, however, in years following. By 1996 a liquid market existed in instruments designed for just such hedging. Credit derivatives are, in essence, insurance policies against a deterioration in the credit quality of borrowers. The simplest ones even require regular premiums, paid by the protection buyer to the protection seller, and make payouts should a specified credit event occur. As noted, credit derivatives may be used by investors to manage the extra risk they take on by opting for the higher returns of non–default-free debt. The instruments can also be used, however, to synthesize the exposure itself, if, for instance, compelling reasons exist for not putting on the cash-market position. Since credit derivatives are OTC products, they can be tailored to meet specific requirements. This material appears as Chapter 10 o
To submit an update or takedown request for this paper, please submit an Update/Correction/Removal Request.