Should we fear derivatives?

A post-crisis point of view on credit derivatives

Bachelor Thesis , 2011 , 30 Pages , Grade: 1,0

Business economics - Banking, Stock Exchanges, Insurance, Accounting

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.

Inhaltsverzeichnis (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

Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)

This paper aims to provide a comprehensive overview of the credit derivatives market, examining its benefits and risks in the context of the financial crisis. It explores how credit derivatives function, their role in financial institutions, and their potential impact on systemic risk. Key themes and objectives of the paper include:

• Understanding the mechanics and trading practices of credit derivatives, focusing on Credit Default Swaps (CDS).
• Assessing the benefits of credit derivatives, such as credit risk transfer and improved market liquidity.
• Evaluating the risks associated with credit derivatives, including issues related to market transparency and systemic risk.
• Analyzing the role of credit derivatives in the financial crisis through case studies of Lehman Brothers and AIG.
• Exploring the potential implications of the findings for other Over-the-Counter (OTC) derivatives.

Zusammenfassung der Kapitel (Chapter Summaries)

Chapter 1: Introduction

This chapter introduces the topic of credit derivatives, highlighting their increasing prominence and contrasting perspectives on their impact before and after the financial crisis. The author outlines the paper's scope and objectives, focusing on the post-crisis understanding of credit derivatives and their potential connection to the financial crisis.

Chapter 2: Principles of Credit Derivatives

This chapter delves into the fundamental features of credit derivatives, emphasizing their characteristics and differentiating them from other Over-the-Counter (OTC) derivatives. The chapter focuses on Credit Default Swaps (CDS) as the most prevalent type of credit derivative, explaining how they are traded and used as a form of insurance against default risk.

Chapter 3: The Credit Derivatives Market

This chapter examines the size and structure of the credit derivatives market, exploring the various market participants, reference entities, and motivations behind the use of credit derivatives. It discusses the increasing importance of CDS indices and the regulatory challenges posed by the lack of transparency in OTC trading.

Chapter 4: The Benefits of Credit Derivatives

This chapter focuses on the advantages of credit derivatives, emphasizing their role in transferring credit risk and enhancing market liquidity. It explores how credit derivatives can provide valuable information about creditworthiness and contribute to a more efficient allocation of credit risk.

Chapter 5: The Risks of Credit Derivatives

This chapter addresses the potential risks associated with credit derivatives, particularly focusing on issues of transparency and systemic risk. It explores the challenges in monitoring and regulating the CDS market and how the lack of transparency can contribute to systemic instability. It analyzes the potential role of credit derivatives in the financial crisis through case studies of Lehman Brothers and AIG, examining how their activities in the credit derivatives market contributed to their distress.

Chapter 6: Implications for Other OTC Derivatives

This chapter discusses the potential implications of the findings on credit derivatives for other OTC derivatives. It explores the similarities and differences between credit derivatives and other types of OTC derivatives and examines the need for greater regulation and transparency in the OTC derivatives market.

Schlüsselwörter (Keywords)

This paper explores the complex world of credit derivatives, focusing on their role in financial markets and their impact on systemic risk. The main keywords and focus topics include: credit derivatives, Credit Default Swaps (CDS), OTC derivatives, systemic risk, market transparency, financial crisis, Lehman Brothers, AIG, regulation, and risk management. The paper examines the benefits and risks of credit derivatives, analyzing their role in credit risk transfer, market liquidity, and the financial crisis.

• College: University of Trier (Professur für Unternehmensfinanzierung und Kapitalmärkte )
• Grade: 1,0
• Author: Hendrik Grobath (Author)
• Publication Year: 2011
• Pages: 30
• Catalog Number: V178563
• ISBN (eBook): 9783656006800
• ISBN (Book): 9783656007326
• Language: English
• Tags: CDS, Credit Default Swaps, Lehman Brothers, AIG, Systemic Risk, Kreditderivate