The credit derivatives market has expanded more than tenfold since its inception in 1993 . Several factors have contributed to the market's growth:
• Increased investor interest in obtaining access to new or less liquid markets;
• The growing sophistication of the credit markets and the resulting search for more favorable relative value transactions versus cash market trades; and
• The desire of corporations and investors to economically hedge longer-term credit exposure.
The market has also benefited from reviews and guidelines provided by the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Bank of England (BOE) and the National Association of Insurance Commissioners (NAIC). Moreover, 1999 year the International Swap Dealers Association (ISDA) introduced standardized documentation for Credit Derivative contracts.
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Credit derivative instruments are standard financial contracts that are now mastered by standardized International Swap Dealers Association (ISDA) documentation.
Credit derivative applications are far reaching. Most importantly, many types of credit derivative applications are not available in traditional corporate bond or loan markets.
The brisk growth of the market has been a result of several factors, but namely the fact that credit derivatives: (1) can offer superior economics to cash market credit instruments; and (2) allow for the efficient hedging of credit risk.
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Business in the biggest market in the world is basically done on a handshake. If you trade stocks, all of the transactions are settled though a central ex-change like the NYSE or NASDAQ; if you trade futures, the CME or the Chicago Board of Trade (CBOT) makes sure that your trades are cleared. It’s the same in options, where the two biggest players, the Chicago Board of Trade (CBOE) and ISE (pronounced “ice” on Wall Street), stand to settle your trades. The exchanges’ main function is to guarantee that disparate groups of buyers and sellers can come to-gether and make trades without having to worry about whether the guy on the other side is good for the money.
Not so in FX. FX is known as the party-to-party market. You deal di-rectly with your market maker and there is no third party guaranteeing the transaction. Everybody works with everybody else on a credit basis. That essentially means that everybody must trust each other to settle up. Settlement, by the way, is two business days forward, but of course due to modern technology every player in the market knows their true exposure in real time.
Decentralization makes the FX market unique. Unlike exchange-based stock or bond markets, there is no central order book and there is no best bid or offer price. In fact, in FX there is no single price for a given currency at any one time. Just like in a Middle Eastern bazaar where prices for identical Persian rugs may differ from one merchant’s stall to the next, so too in FX prices for EUR/USD may vary depending on which dealer’s quote you receive. This process may seem bewildering and arcane, but the wide array of participants actually makes the FX market the most efficient and liquid in the world. In reality, competition among mar-ket makers is so fierce that the bid/ask difference in the the EUR/USD— the most active financial instrument in the world—is often only 1 point wide, equivalent to only 0.01
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