Basics of Credit Derivatives

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Evolution of credit derivatives

Many people claim that credit derivatives evolved in 1995, but they are wrong. Credit derivatives emerged in early 1993 or even before that. In March 1993, Global Finance carried an article which said that three Wall Street firms - J. P. Morgan, Merrill Lynch, and Bankers Trust - were already then marketing some form of credit derivatives. Prophetically, this article also said that credit derivatives could, within a few years, rival the $4-trillion market for interest rate swaps. In retrospect, we know that this was right.

Not only were credit derivatives already a topic frequently talked about in financial press in 1993, they initially faced a bit of resistance. In Nov. 1993, Investment Dealers Digest carried an article titled Derivatives pros snubbed on latest exotic product which claimed that a number of private credit derivative deals had been seen in the market but it was doubted if they were ever completed. The article also said that Standard and Poor's had refused to rate credit derivative products and this refusal may put a permanent damper on the fledgling market. S&P seems to have issued some kind of a document which said that in essence, these securities represent a bet by the investor that none of the corporate issuers in the reference group will default or go bankrupt.

One commentator quoted in the said article said: "It (credit derivatives) is like Russian roulette. It doesn't make a difference if there's only one bullet: If you get it you die".

Almost 3 years later, Euromoney reported [March 1996: Credit derivatives get cracking ] that a lot of credit derivatives deals were already happening. From a product that was branded as a "touted" product in 1993, the market perception had changed into one of unbridled optimism. The article said: "The potential of credit derivatives is immense. There are hundreds of possible applications: for commercial banks which want to change the risk profile of their loan books; for investment banks managing huge bond and derivatives portfolios; for manufacturing companies over-exposed to a single customer; for equity investors in project finance deals with unacceptable sovereign risk; for institutional investors that have unusual risk appetites (or just want to speculate); even for employees worried about the safety of their deferred remuneration. The potential uses are so widespread that some market participants argue that credit derivatives could eventually outstrip all other derivative products in size and importance."

Here are some significant milestones in the development of credit derivatives:

  • 1992 - Credit derivatives emerge. Isda first uses the term "credit derivatives" to describe a new, exotic type of over-the-counter contract.
  • 1993 -KMV introduces the first version of its Portfolio Manager model, the first credit portfolio model.
  • 1994 - Credit derivatives market begins to evolve. There are doubts expressed by some - as above.
  • September 1996 - The first CLO of UK's National Westminster Bank.
  • April 1997 - J P Morgan launches CreditMetrics
  • October 1997 - Credit Suisse launches CreditRisk+
  • December 1997 - The first synthetic securitisation,
    JP Morgan's Bistro deal.
  • July 1999 - Credit derivative definitions issued
    by Isda.