Modelling Single-name and Multi-name Credit Derivatives by Dominic O’Kane

1

The Credit Derivatives Market
1.1 INTRODUCTION
Without a doubt, credit derivatives have revolutionised the trading and management of credit
risk. They have made it easier for banks, who have historically been the warehouses of credit
risk, to hedge and diversify their credit risk. Credit derivatives have also enabled the creation
of products which can be customised to the risk–return profile of specific investors. As a result,
credit derivatives have provided something new to both hedgers and investors and this has been
a major factor in the growth of the credit derivatives market.
From its beginning in the mid-1990s, the size of the credit derivatives market has grown
at an astonishing rate and it now exceeds the size of the credit bond market. According to
a recent ISDA survey,1 the notional amount outstanding of credit derivatives as of mid-year
2007 was estimated to be $45.46 trillion. This significantly exceeds the size of the US corporate
bond market which is currently $5.7 trillion and the US Treasury market which is currently
$4.3 trillion.2 It also exceeds the size of the equity derivatives market which ISDA also estimated
in mid-2007 to have a total notional amount outstanding of $10.01 trillion.
In addition to its size, what is also astonishing about the credit derivatives market is the
breadth and liquidity it has attained. This has been due largely to the efforts of the dealer
community which has sought to structure products in a way that maximises tradabililty and
standardisation and hence liquidity. The CDS indices, introduced in 2002 and discussed extens-

ively in this book, are a prime example of this. They cover over 600 of the most important
corporate and sovereign credits. They typically trade with a bid–offer spread of less than 1
basis point and frequently as low as a quarter of a basis point.3
To understand the success of the credit derivatives market, we need to understand what it can
do. In its early days, the credit derivatives market was dominated by banks who found credit
derivatives to be a very useful way to hedge the credit risk of a bond or loan that was held on
their balance sheet. Credit derivatives could also be used by banks to manage their regulatory
capital more efficiently. More recently, the credit derivatives market has become much more
of an investor driven market, with a focus on developing products which present an attractive
risk–return profile. However, to really understand the appeal of the credit derivatives market,
it is worth listing the many uses which credit derivatives present:
• Credit derivatives make it easier to go short credit risk either as a way to hedge an existing
credit exposure or as a way to express a negative view on the credit market.

• Most credit derivatives are unfunded. This means that unlike a bond, a credit derivative
contract requires no initial payment. As a consequence, the investor in a credit derivative
does not have to fund any initial payment. This means that credit derivatives may present a
cheaper alternative to buying cash bonds for investors who fund above Libor. It also makes
it easier to leverage a credit exposure.
• Credit derivatives increase liquidity by taking illiquid assets and repackaging them into a
form which better matches the risk–reward profiles of investors.
• Credit derivatives enable better diversification of credit risk as the breadth and liquidity of
the credit derivatives market is greater than that of the corporate bond market.
• Credit derivatives add transparency to the pricing of credit risk by broadening the range
of traded credits and their liquidity. We estimate that there are over 600 corporate and
sovereign names which have good liquidity across the credit derivatives market.4 The scope
of the credits is global as it includes European, North American and Asian corporate credits
plus Emerging Market sovereigns.
• Credit derivatives shift the credit risk which has historically resided on bank loan books
into the capital markets and in doing so it has reduced the concentrations of credit risk in
the banking sector. However, this does raise the concern of whether this credit risk is better
managed in less regulated entities which sit outside the banking sector.
• Credit derivatives allow for the creation of new asset classes which are exposed to new risks
such as credit volatility and credit correlation. These can be used to diversify investment
portfolios.
The relatively short history of the credit derivatives market has not been uneventful. Even
before the current credit crisis of 2007–2008, the credit derivative market has weathered
the 1997 Asian Crisis, the 1998 Russian default, the events of 11 September 2001, the
defaults of Conseco, Railtrack, Enron, WorldCom and others, and the downgrades of Ford
and General Motors. What has been striking about all of these events is the ability of
the credit derivatives market to work through these events and to emerge stronger. This
has been largely due to the willingness of the market participants to resolve any prob-

lems which these events may have exposed in either the mechanics of the products or their
legal documentation. Each of these events has also strengthened the market by demon-

strating that it is often the only practical way to go short and therefore hedge these credit
risks.
In this chapter, we discuss the growth in the credit derivatives market size. We present an
overview of the different credit derivatives and discuss a market survey which shows how the
importance of these products has evolved over time. We then discuss the structure of the credit
derivatives market in terms of its participants.
1.2 MARKET GROWTH
The growth of the credit derivatives market has been phenomenal. Although there are different
ways to measure this growth, each with its own particular approach, when plotted as a function

Modelling Single-name and Multi-name Credit Derivatives by Dominic O’Kane