Applications of Credit Derivatives. Opportunities and Risks involved in Credit Derivatives by Harald Seemann

1. Current Issue
The traditional bank credit is a central business activity of financial institutions. 
Globalization and the dispersion of large companies have lead to fierce competition in terms 
of capital market financings versus classical credit financings. This scenario has increased 
product innovation tremendously. As a consequence of rising credit defaults and failed 
evaluation of default probabilities during various crises in the past, banks have created an 
attractive field of profit to trade credit risks based on a pooled portfolio or on single credits: 
the credit derivatives market. It allows trading of credit risks between various parties, ranging 
from commercial banks, asset managers, insurance companies, investment banks and hedge 
funds to corporations. 
Credit derivatives are financial instruments which allow the splitting and transfer of credit 
risk without influencing the original credit relationship between the credit originator and the 
credit borrower. Credit derivative deals can be negotiated between the counterparts and 
transfer only the defined credit risk against payment of a certain risk premium. A risk seller, 
the party seeking credit risk protection, may want to reduce exposures while maintaining 
relationships that may be endangered by selling their loans, reduce or diversify illiquid 
exposures, or reduce exposures while avoiding adverse tax or accounting treatment. A risk 
buyer, the party assuming credit risk, may want to diversify credit exposures, get access to 
credit markets which are otherwise restricted by corporate statute or which are off-limits by 
regulation, or simply exploit arbitrage pricing discrepancies. For example, arbitrage 
opportunities in the credit derivatives market result from perceived mispricings between bank 
loans and subordinated debt of the same issuer. 
At first sight, credit derivatives offer attractive benefits to the counterparts involved. The 
transfer of credit risk against a premium makes credit markets more efficient, facilitates credit 
offerings from banks to young start ups and supports economic growth and innovation. 
Concentration risk can be avoided easily. Compared to bonds, for which companies have to 
fulfil huge amounts of regulation documents, credit derivatives do not require long approvals. 
Deals are completed directly between counterparts over the counter (OTC) or in cooperation 
with the major players in this market. 
The legal frame for this market is still underdeveloped and transactions cannot always be fully 
tracked by legal authorities. This explains the explosive growth of the credit derivatives

market: the current volume amounts to more than 20.2 trillion US-Dollars on aggregated 
terms. Since 2006, the relative size of the credit derivatives market is higher than the 
corporate bonds market.

It is interesting to note that the credit derivatives market has tripled in the span of a few years. 
Efficient execution and risk management systems as well as high liquidity and easy 
accessibility allow market participants to trade credit protection whenever they need it. The 
application of credit derivatives reaches a constantly growing target. Hedge funds have 
become a major force in the credit derivatives market; their share of volume in both buying 
and selling credit protection has almost doubled since 2004. Banks constitute the majority of 
market share and almost two-thirds of the volume in credit derivatives by banks is due to 
trading and a third is related to their loan book only.

Applications of Credit Derivatives. Opportunities and Risks involved in Credit Derivatives by Harald Seemann