Should we fear derivatives?

A post-crisis point of view on credit derivatives

by Hendrik Grobath (Author)

Bachelor Thesis 2011 30 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting


Table of contents

1 Introduction

2 Principles of credit derivatives
2.1 What are credit derivatives and how are they traded?
2.2 How do credit derivatives differ from other OTC derivatives?

3 The credit derivatives market
3.1 The size of the credit derivatives market: a risk indicator?
3.2 Market participants in the CDS market
3.3 CDS reference entities
3.4 Why are credit derivatives used?

4 The benefits of credit derivatives
4.1 Credit risk transfer and the allocation of credit risk
4.2 CDS and credit market liquidity
4.3 The informational value of credit derivatives

5 The risks of credit derivatives
5.1 CDS and market transparency
5.1.1 Transparency gaps in the CDS market
5.1.2 The lack of transparency in Lehman Brothers’ CDS settlement
5.2 CDS and systemic risk
5.2.1 Linkages between CDS and systemic risk
5.2.2 Theoretical framework: measuring the systemic importance of an institution .
5.2.3 The systemic importance of AIG
5.2.4 The role of CDS in AIG’s liquidity crisis
6 Implications for other OTC derivatives

7 Conclusion


1 Introduction

[...] instruments that are more complex and less transparent--such as credit default swaps, [...]--have been developed and their use has grown very rapidly in recent years. The result? [sic] Improved credit-risk management together with more and better risk-management tools appear to have significantly reduced loan concentra- tions [...] and the associated stress on banks and other financial institutions.

Alan Greenspan, Chairman of the Federal Reserve, 19 November 2002 (The Federal Reserve Board, 2002). [...] What I wanted to point out was that - excluding credit default swaps - derivatives markets are working well.

Alan Greenspan, Former Chairman of the Federal Reserve, 23 October 2008 (The European Institute, 2009).

The contradictory statements by Alan Greenspan, former chairman of the Federal Reserve, illustrate the role of credit derivatives before and after the financial crisis. Credit derivatives and related instruments were seen as important hedging tools after the corporate crises in 2001 and 2002. By contrast, the distress in financial markets during the subprime mortgage crisis was partly traced to these instruments.

This paper provides an up-to-date perspective on the credit derivatives market. It explains why financial institutions are active in this market and which positions they incorporate. Moreover, gaps in credit derivatives trading will be outlined. The findings will be used to assess the most commonly stated benefits and risks of credit derivatives.

The potential linkages between credit derivatives and the financial crisis are also addressed. Lehman Brothers and AIG will be used as examples to answer the question on whether the distress of major financial institutions during the financial crisis can be related to credit de- rivatives. These institutions have been highly active in the credit derivatives market. Finally, it will be asked whether the findings in this paper are applicable for other over-the- counter (OTC) derivatives.

This paper will come up with a conclusion on whether the benefits or risks of these instru- ments are prevailing and suggests ways on how regulators should address OTC markets in the future.

2 Principles of credit derivatives

This chapter explains the main features of credit derivatives including its important character- istics and differences from other OTC derivatives. In the succeeding chapters, the focus lies on the analysis of Credit Default Swaps (CDS). Henceforth, credit derivatives and CDS have the same meaning.

2.1 What are credit derivatives and how are they traded?

Consider a bank holding a portfolio of bonds. Under normal circumstances the bank is paid a fixed coupon rate and will receive the face value of the bond at maturity date. In times of financial distress, the bank may be exposed to default risk of these bonds. Here, credit derivatives can be potential insurance tools.

They provide protection on reference entities such as companies or countries. Credit deriva- tives enable banks to reduce their external exposure by trading credit risks. (Hull, 2008, p. 525)

Surveys undertaken by the Bank for International Settlements (BIS) show that CDS are the most common credit derivatives. They represent 88.4 % of total credit derivatives in June 2007 and 98.9 % in June 2010. (BIS, 2010, p. 13)

A CDS is a contract between two parties, a buyer and a seller of protection. The protection buyer can claim insurance in the case of default of a particular company or country. The buyer pays a periodic premium to the seller of protection. This periodic premium is paid as a per- centage of the CDS’ face value. It is called CDS spread. In return, the protection seller will ei- ther physically deliver the bond or provide cash payment in the case of default. (Hull, 2008, p. 25-26)

The European Central Bank (ECB) (2009, p. 9) defines the main types of CDS. Two of them, single-name and basket CDS, are presented in the following. Single-name CDS provide protection for one particular company or country. Basket CDS refer to portfolios of reference entities. In 2010, single-name products represent 60.6 % and basket CDS account for 39.4 % of CDS notional amounts outstanding. (BIS, 2010, p. 13)

Credit derivatives are primarily traded OTC (ECB, 2009, p. 9). That is, transactions occur di- rectly between two parties. Besides OTC trading, indices for CDS became more important. CDS indices consist of a pool of single-name CDS (ibid.). Out of USD 31.4 trillion CDS no- tional amount outstanding, USD 7.6 trillion are referred to index products in 2010. In earlier reports on derivatives market activity the BIS did not include index products. (BIS, 2007, p. 12 and 2010, p. 13)

Hence, while counting for a relatively small fraction of CDS notional amounts, the develop- ment in absolute numbers is outstanding. The ECB (2009, p. 9) finds that this growth is due to higher standardisation and the transparency of indices.

Meanwhile, OTC derivatives have been criticised for being lightly regulated. As a consequence of the financial crisis, regulators asked for higher transparency in credit derivatives trading. (Singh, 2010, p. 3)

One opportunity in enhancing transparency is the use of central clearing counterparties (CCPs). A CCP stands between OTC derivatives counterparties. It acts as intermediary by figuring the buyer and the seller of a transaction. (ECB, 2009, p. 50)

To illustrate, suppose a protection seller insures his CDS portfolio by buying protection for the reference entities he assures. The initial bilateral agreement will then include another party. Traditional OTC trading would not insure the three parties involved from each other´s risk of default. Trading through a CCP reduces the effects of defaults to the counterparties (Duffie and Zhu, 2011, p. 2).

The recent financial crisis uncovered serious gaps in credit derivatives trading. The future of the CDS market will depend on how these gaps will be addressed by regulators.

2.2 How do credit derivatives differ from other OTC derivatives?

The value of a derivative depends on the development of an underlying financial instrument (Rudolph and Schäfer, 2005, p. 15). Suppose there is an interest rate swap (IRS) where two parties exchange fixed and floating rate interest payments (Hull, 2008, p. 147). A rise in inter- est rates negatively affects the party paying floating rate. Meanwhile, the party which is pay- ing the fixed rate but receiving floating rate, benefits from higher interest rates. This symmetrical structure applies to a number of OTC derivatives: the one side’s loss is the other side’s profit (Stulz, 2004, p. 186). Credit derivatives differ from this structure (Mengle, 2007, p. 2). A credit event, e.g. the default of a reference entity, is neither a gain for a protec- tion buyer nor for a protection seller. The protection seller is responsible for compensating the protection buyer in this case. Depending on contractual terms, the protection buyer may re- ceive the face value of the bond and stops making periodic payments to the seller of protec- tion. Nonetheless, he loses his investment opportunity. Hence, both parties are in a disadvan- tageous situation.

Moreover, risks of the underlying financial instruments differ considerably. Counterparties in OTC derivatives, excluding credit derivatives, primarily face volatility risk of e.g. interest rates, currencies or equity indices. Counterparties in CDS are concerned with the creditwor- thiness of a particular company or country. The changes in interest rates, currencies and eq- uity indices are transparent. Fluctuations in interest rates for example are widely publicized. In contrast, the creditworthiness of a company or country is not compulsorily transparent.

This makes information gaps between CDS counterparties possible. One party may be better informed about the creditworthiness of a reference entity than the other. Hence, asymmetric information between the buyer and the seller of protection is crucial in CDS trading. (Rudolph et al., 2007, p. 27)

OTC derivatives involve two parties negotiating either directly or through an intermediary (Hull, 2008, p. 2). In addition to the risk of the underlying financial instrument, counterparty risk is very important in OTC trading (Segoviano and Singh, 2008, p. 5). Consider an IRS and a CDS and assume that the IRS is initiated directly between two parties. When one counterparty defaults, the remaining exposure equals the difference between cash flows of fixed and floating interest rate payments in an IRS (Bomfim, 2002, p. 7). On the other hand, both the protection buyer and the protection seller may default in a CDS. With the default of the protection buyer, the protection seller loses his income from the CDS premium (Mengle, 2007, p. 2). The protection buyer is concerned about two incidents. First is when the protection seller defaults. In this case, the engagement of another protection seller with the same contractual terms with the reference entity is needed. Second is when both the reference entity and the protection seller default. The protection buyer loses his insurance and is fully exposed to the investment loss. (ibid.)

Hence, counterparty risk in CDS is not referred to an exchange of cash flows. In a worst case scenario, the buyer of protection may solely bear the default of the reference entity. The risk that one counterparty defaults may lead to systemic concerns if this party has a large derivative portfolio (Duffie et al., 2010, p. 5). It is to be clarified whether this concern equally affects CDS and other OTC derivatives. This will be done in a final section.

3 The credit derivatives market

This chapter points out the composition of the CDS market. This provides a basis for the later analysis of the benefits and risks of credit derivatives. Market data published by the BIS and the Depository Trust & Clearing Corporation (DTCC) will be used. One must be aware that differences between both data sources exist (Gyntelberg et al., 2009 cited in BIS, 2009, p. 24). The DTCC breaks down CDS notional amounts by reference entity segments. Moreover, CDS gross and net notional amounts for the top 1,000 reference entities are published. This data provides an additional perspective. Despite existing differences, both sources will be included in the following discussion.

3.1 The size of the credit derivatives market: a risk indicator?

Two approaches used to measure the size of the credit derivatives market will be shown. In a comparison with gross market values of credit derivatives, it will be discussed whether market size is a useful risk indicator.

Most commonly, the size of the CDS market is assessed by notional amounts. A CDS notional is the face value of credit protection bought or sold (International Swaps and Derivatives Association (ISDA), 2009).

According to survey data from the BIS (2007, p. 10 and 2010, p. 13), the total notional amount outstanding for all types of credit derivatives was USD 4.5 trillion in 2004, USD 51.1 trillion in 2007 and USD 31.4 trillion in 2010.

This development is remarkable. However, the interpretation of notional amounts is difficult. For instance, one party may be both protection buyer and seller for one single reference entity. To illustrate, consider that A sells protection to B. Then A decides to buy protection on the same reference entity from C. The total gross notional amount on the particular reference entity would then equal the sum of the notional amounts in both contracts. In this case, the net exposure would be overestimated.

For this reason, the second approach looks at net notional amounts. Suppose that the CDS’ notional in the above example was USD 1,000. The gross notional amount for the reference entity increases if A buys protection from C. On the contrary, the net exposure remains to be USD 1,000. The net notional value is the maximum amount of money that could be delivered from the net protection seller to the net protection buyer after a credit event (ECB, 2009, p. 16).

The DTCC (2011a) publishes both gross and net notional amounts of single name reference entities on a weekly basis. For the week ending 24 June 2011, CDS gross notional amounts account for USD 15.5 trillion, while net notional amounts represent USD 1.2 trillion. Ex- pressed as a percentage of gross notional amounts, net notional amounts only measure 7.8 %. However, the net exposure still tends to overestimate the cash flow obligation after a credit event. As mentioned before, it is assumed that the largest amount possible needs to be paid af- ter a credit event. This is rather abstract. It applies if the recovery rate of the underlying bond is zero. In theory, this may be the case. However, the implication of recovery rates is much more reasonable. The net payment obligation after a credit event can then be calculated. (ECB, 2009, p. 16)

Market values are included to draw a comparison with the above approaches. Notional amounts are set with the completion of a CDS contract. Thereafter, the CDS notional of a deal does not change. Market values vary with market conditions. (Stulz, 2010, p. 79) The ECB (2009, p. 17) defines the mark-to-market value of a CDS as the cost of replacing a transaction on a particular date.

The assessment of the fair value of a CDS is based on two legs. First is the fee leg, which re- fers to the CDS spread the protection buyer pays periodically. Second is the default leg which corresponds to the payment to be made by the protection seller if the reference entity defaults. The current CDS spread on a reference entity can be used to determine the default leg. Finally, the difference between both legs is discounted at a risk adequate rate. (ibid.) The above assessment procedure points out the role of CDS spreads as risk indicators. CDS spreads increase if the default of a reference entity becomes more likely. On the other hand, it decreases if default becomes less likely.

Variations in CDS spreads are reflected in market values. Consider an investor who buys protection on a given reference entity at a spread of 100 basis points. If the CDS spread increases to 150 basis points, the investor makes an unrealised market gain of 50 basis points. That is, the market value of protection bought rises if the default of the reference entity becomes more likely (Stulz, 2010, p. 79).

The BIS publishes CDS total gross market values semi-annually. Gross market values are measured by adding all CDS dealers’ contracts with positive market value to dealers’ contracts with negative market values. They are calculated at market prices of the reporting date. (BIS, 2011a, pp. 4-5)

The gross market value of total credit derivatives was USD 131 billion in 2004, USD 906 bil- lion in 2007 and USD 1.708 trillion in 2010 (BIS, 2007, p. 10 and 2010, p. 13). This repre- sents 2.9 % of total notional amounts outstanding in 2004, 1.8 % in 2007 and 5.4 % in 2010. Thus, gross market values are considerably small in comparison with notional amounts out- standing. They do reflect the extent of potential market risk in CDS transactions (BIS, 2011a, p. 5).

Meanwhile, gross market values are not an indicator for counterparty risk (ECB, 2009, p. 17). Contracts with positive and negative values with the same counterparty are not netted (BIS, 2011a, p. 5). Hence, the information function of market values is limited to market risk. This section showed that market size is not a useful risk indicator. It is most likely to overstate the net payment exposure.

3.2 Market participants in the CDS market

The credit derivatives market is dominated by a small number of financial institutions. Four major types of market participants are presented. These are banks classified as dealers, banks not classified as dealers, insurance companies and hedge funds.

The main players in the credit derivatives market are large investment banks. They primarily operate as dealers in OTC trades. That is, they offer bid and ask prices on particular reference entities to external market participants. (ECB, 2009, p. 21)

The ECB (ibid.) finds that JPMorgan, Goldman Sachs, Morgan Stanley, Deutsche Bank and Barclays were the five largest dealers in 2008. According to the BIS (2010, p. 20), dealers of credit derivatives hold 55.3 % of CDS gross market values in the first half of 2010. Credit derivatives are highly traded among the dealers themselves (ECB, 2009, p. 21). They tend to match their exposure to external market participants in the inter-dealer market. This leads to a high level of interconnection between the dominating players (ibid.). Banks that are not classified as dealers are the second group of market participants. This group comprises commercial and investment banks. They represent 26.3 % of CDS gross market values in the first half of 2010 (BIS, 2010, p. 20). According to the ECB (2009, p. 10), these banks use CDS in order to manage their credit risk exposure. They usually buy CDS protection to hedge credit risk deriving from bonds in their portfolios.

Insurance companies account for 1.9 % of CDS gross market values in 2010 (BIS, 2010, p. 20). The BIS also includes pension funds in this group (BIS, 2011, p. 6). The net fraction of insurance companies must be slightly smaller. The inclusion of pension funds in the data forecloses a statement on their pure CDS market activities. In principle, insurance companies were categorised as large protection sellers in CDS before the financial crisis (ECB, 2009, p. 10).

The ECB (ibid., p. 23) finds that market exits by large institutions such as AIG took place after the crisis. If this is correct, there must be another group of market participants that replaced them in outstanding selling positions.

Data published by the DTCC shows that euro area banks appear as net sellers of protection (ibid., p. 24). This observation may serve as a snap-shot rather than an indicator for a long- term change in the CDS market. However, market exits must be compensated by other parties. The question on who replaces these institutions is of high importance. If banks really fill this gap, the concentration of CDS in the banking sector rises. This is a potential source of risk.

Hedge funds represent 2.7 % of CDS gross market values in 2010 (BIS, 2010, p. 20). Prior to the financial crisis, hedge funds used to be protection sellers in CDS. Similar to insur- ance companies, hedge funds reduced their activity in CDS trading after the financial crisis. (ECB, 2009, p. 4)

These four groups of market participants played an outstanding role in the credit derivatives market before the financial crisis. They still account for 86.2 % of CDS gross market values (BIS, 2010, p. 20).

Meanwhile, non-financial firms hardly use credit derivatives. In a survey on risk management, Bodnar, et al. (2011, p. 54) find that only 5 %1 apply credit derivatives to hedge their credit exposure. In comparison, 44 % of financial firms use credit derivatives to hedge credit risk.


1 The percentage of credit derivatives refers to the sum of CDS and total return swaps.


ISBN (eBook)
ISBN (Book)
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Institution / College
University of Trier – Professur für Unternehmensfinanzierung und Kapitalmärkte
CDS Credit Default Swaps Lehman Brothers AIG Systemic Risk Kreditderivate


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    Hendrik Grobath (Author)


Title: Should we fear derivatives?