Technische Universität München Credit as an Asset Class - risklab

CHAPTER 2. CREDIT RISK TRANSFER
tailored for the specific needs of a market participant. Thus, they help investors to better
manage their credit risk exposure. They also allow for synthesising assets that would not
be available for certain investors or that even do not exist.
Credit derivatives are also used for the purpose of speculation. A market participant
does not need to have an exposure to a debt instrument to enter into a credit derivative
contract. Credit derivatives can rather be used to express one’s opinion about future
credit quality of a reference entity, and that way to financially participate in its changes
by trading these instruments. For the investor, the underlying itself is irrelevant. He is
only interested in generating a profit from trading.
Another kind of market participant is an arbitrageur, who tries to benefit from pricing
differences in two or more markets.
2.3.4 Chances and Risks related to Credit Derivatives Markets
The credit derivatives markets incorporate both chances and risks, which are described in
this section.
Chances related to Credit Derivatives Markets
On a microeconomic level, credit derivatives are instruments for credit risk transfer, partly
comparable to traditional instruments for credit risk transfer such as loan sale or credit
insurance. The characteristics of the derivatives and their possible applications, however,
go far beyond those of the traditional instruments such as loan sales and credit insurance.
Credit derivatives allow banks to isolate and to trade credit risks as well as to dynamically
adjust their credit risks, and thus optimising their risk profile.
On a macroeconomic level, the utilisation of credit derivatives can contribute to im-
prove the overall risk allocation within financial systems, which can be accomplished in the
following ways: First, banks are enabled to perform risk management in a more flexible
and efficient way. Second, the increased trading activities improve the transparency and
the quality of the pricing. Third, credit risk is distributed more efficiently. Hence, the
aggregated risk within a national economy is reduced and market crises can be better ab-
sorbed as risks and possibly implied damages are less concentrated. All in all, the stability
of the financial system can be increased. 25
Risks related to Credit Derivatives Markets
We examine the risks induced by credit derivative contracts. Table 2.1 gives an overview
on the possible risks inherent in credit derivatives markets.
The risks related to the credit derivatives markets can be classified into two groups:
Risks on contract level and risks on market level. At first, we explain the risks on contract
level.
• Counterparty risk – risk that one of the counterparties (protection seller or buyer)
is unable to fulfil its contractual obligations.
25 See [DBR04], pp. 1-3 and [Deu04], pp. 36-37.
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