One of the risks of making a bank loan or investing in a debt security is credit risk, the risk of borrower default. In response to this potential problem, new financial instruments called credit derivatives have been developed in the past few years. Credit derivatives can help banks, financial companies, and investors manage the credit risk of their investments by insuring against adverse movements in the credit quality of the borrower.
This paper provides a brief introduction to basic credit derivatives, discusses their applications, and also summarizes some leading models for the pricing of credit derivatives. As with other derivatives, credit derivatives pose multi-dimensional risks. This paper analyzes the risks incurred by financial institutions that use credit derivatives and also suggests several systematic ways to control these risks. Finally, the supervisory treatment of credit derivatives in major developed countries was discussed.
