Institutional management of credit derivatives

Abstract

The credit derivatives market has grown dramatically in the last three years and with that growth has come new opportunities for financial institutions to take advantage of this market. In this paper, we explore these market developments and lay a conceptual framework for the strategic management of credit derivatives by banking institutions. We argue that the development of the market now means that banks need to choose a strategic path for their credit derivative operations, and more specifically whether they will use the instruments simply as a tool for portfolio management, or participate in the market as a market-maker. The study of credit risk has gained rapidly in importance in recent years, mainly due to the emergence of the credit derivative market. Most of the research and analysis has been focused on the pricing of credit risk and or credit derivatives, while little attention has been given in the academic literature to the structural implications of the developing credit derivative market. Furthermore, even less attention has been paid to the managerial issues that arise with the development of this still relatively new market that has the potential to radically change the allocation, pricing, regulation and management of credit risk. In this paper we attempt to start a dialogue on the management issues of credit derivatives and to lay a conceptual framework for studying the issues. The central conclusion is that a banking institution needs to determine the depth and extent of its operations and more fundamentally determine whether as an institution it will be utilizing the credit derivatives market as an end-user for credit management or as a market maker intending to make a profit from trading and servicing clients. Section one gives a brief overview of credit derivatives. The second section describes the features of this market as it concerns banking as an industry, while section three discusses some of the managerial implications. The fourth and final section concludes and provides some directions for further research and analysis.