Risk -- Nov., 2006 issue
Dealers are trading increasingly high volumes of bespoke tranches of synthetic credit risk with each other, yet there still appears to be little consensus on the application of credit models. Is there a danger the house of cards may come tumbling down?
The credit derivatives market is growing at a pace unprecedented in financial markets. From a non-existent business 10 years ago, the value of outstanding notionals stood at more than $26 trillion as of June, according to the latest survey from the International Swaps and Derivatives Association. That's more than four times the size of the over-the-counter equity derivatives market.
The development of the market has proven to be a major boon for loan portfolio managers that can synthetically sell on their over-concentrated exposures to reduce counterparty risk. And the fusion of derivatives technology and credit derivatives has offered end-investors the opportunity to purchase customised credit portfolio exposures at pre-specified risk/reward trade-offs. To provide these bespoke portfolios, dealers have delta-hedged their exposures using single-name credit default swaps (CDSs), credit indexes and index tranches.
In fact, the engine of growth in the credit derivatives market has been in the use of indexes. A Fitch Ratings study published in September says trades related to indexes and index-related products grew by 900% in 2005 to $3.7 trillion by the end of that year.
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