Credit derivatives offer a wide range of capital market applications. Participants include banks, insurance companies, total return investors, mutual funds and hedge funds. Additionally, corporations have recently begun to use credit derivatives to hedge capital market activities and business risks. Market participants are motivated to use credit derivatives for 1) relative value; 2) market access; 3) hedging and risk management; and 4) management of indirect or noneconomic costs.
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Credit derivatives on high yield credits are also becoming more popular as convertible bond investors hedge embedded credit risk to isolate equity risk.
To date, the primary users of credit derivatives have been commercial banks, using default swaps to take their loans off-balance sheet. Recently, the investor base has broadened to include: money managers, mutual funds, and insurance companies. The primary area of growth has been the new "sellers" of credit protection such as reinsurance companies, life insurance companies and CP conduits who have come on-line for default swaps in the past six months.
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Credit derivatives are the natural extension of the credit market. They complete the credit market, just as their more mature interest rate and equity derivative counterparts completed their underlying markets many years ago.
The underlying credits of credit derivative instruments are well represented in the cash market. Often, the activity in a particular credit on the derivative front is linked to an expected change in credit fundamentals, and accordingly cash market spread volatility. Credits in which there are sizable cash market or counterparty exposures are also actively
Despite the market's youth, it has already been tested by severe stresses; it successfully weathered both the emerging market and hedge fund crises of 1998. Volume declined in the period following these events , but has since resumed a steady growth trajectory. The effect was in two respects healthy for the market as it : 1) heightened attention to documentation issues and problems; and 2) encouraged the eventual standardization of documentation that was implemented in the summer of
1999.
As the market has grown, liquidity— an important consideration for potential market participants— has improved. While liquidity varies by instrument and credit, the most established products offer good liquidity. Document standardization has also led to an increase in market liquidity. The ability for market makers to deal through brokers with an underlying template has led to tighter bid/ask spreads in the market and improved execution for end "buyers and sellers" of credit protection.
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