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 derivatives. 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 instruments are prevailing and suggests ways on how regulators should address OTC markets in the future.
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
References
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