Credit Derivatives and Risk Management
Michael S. GibsonFRB Atlanta Financial Markets Conference
Sea Island, GeorgiaMay 15, 2007
Disclaimer
This paper represents the views of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or other members of its staff.
Credit derivative notional amounts
0
10
20
30
40
2001 2006
$ trillion
Motor vehicle registrations
0
2
4
6
8
10
1900 1920
million
Risk management!
Motor vehicle traffic deaths
0
2
4
6
8
10
1900 19200
10
20
30
40
50million Per million
motor vehicles
Credit Derivatives
Why are they growing?
What are the risks?
Credit Derivatives
Why are they growing?
What are the risks?
Useful for risk management
Useful for risk management
1.2.3.
Useful for risk management
1. Commercial banks2.3.
Useful for risk management
1. Commercial banks2. Investment banks3.
Useful for risk management
1. Commercial banks2. Investment banks3. Investors
– buy and hold– active trader– credit index tranches
Credit index tranches
22 – 100%
12 – 22%
9 – 12%6 – 9%3 – 6%
0 – 3% of losses
Not marketed
Investor E
Investor DInvestor CInvestor BInvestor A
Credit index tranches
22 – 100%
12 – 22%
9 – 12%6 – 9%3 – 6%
0 – 3% of losses
Not marketed
Investor E
Investor DInvestor CInvestor BInvestor A
0.51.3
2.6
8.1
12-22 Index 9-12 6-9 3-6
Relative default riskof 10-year tranches(Index = 1)
1
0.8
2.1
4.25
11
12-22 Index 9-12 6-9 3-6
Relative spread riskof 10-year tranches(Index = 1)
1
0.51.3
2.6
8.1
0.8
2.1
4.25
11
12-22 Index 9-12 6-9 3-6
Both measures ofrelative risk(Index = 1)
1
Credit Derivatives
Why are they growing?
What are the risks?
The risks are:
1.2.3.4.5.
The risks are:
1. Credit risk2.3.4.5.
The risks are:
1. Credit risk2. Counterparty risk3.4.5.
The risks are:
1. Credit risk2. Counterparty risk3. Model risk4.5.
The risks are:
1. Credit risk2. Counterparty risk3. Model risk4. Rating agency risk5.
0.51.3
2.6
8.1
0.8
2.1
4.25
11
12-22 Index 9-12 6-9 3-6
Both measures ofrelative riskwith credit rating(Index = 1)
1
AAA AAAA-/BBB+ A B+
The risks are:
1. Credit risk2. Counterparty risk3. Model risk4. Rating agency risk5. Settlement risk