Credit Derivatives and Risk Management

E C O N O M I C R E V I E W Fourth Quarter 2007 The growth of credit derivatives suggests that market participants find them useful for risk management. Figure 1 shows the growth trajectory for credit derivatives from two surveys of derivatives dealers: the International Swaps and Derivatives Association (ISDA) Market Survey, which goes back to 2001, and the Bank for International Settlements (BIS) semiannual derivatives statistics (2007), which go back to 2004. The BIS survey is more accurate because it adjusts for double counting of interdealer trades, but both surveys show a similar pattern of rapid growth. Notional amounts of credit derivatives outstanding have roughly doubled each year for the past five years. Credit derivatives have been used by a wide variety of market participants. No single data source provides definitive information on the activity of different types of market participants, but combining several available data sources provides a relatively clear picture. I will refer to three data sources: the BIS semiannual derivative statistics (2007), a report on credit risk transfer by the Joint Forum (BIS 2005a), and the surveys by Fitch Ratings (2006). All three data sources measure activity in the credit derivatives market with notional amounts. Notional amounts are often not a good measure of the credit risk that is actually transferred in a particular transaction. However, notional amounts are relatively easy data to collect, and for this reason they are the most common data reported. I will present the notional amount data while keeping their limitations in mind. The most comprehensive data source is the BIS semiannual derivative statistics (BIS 2007). About fifty-five dealers contribute to this survey, which breaks out credit derivative notional amounts by the type of counterparty. Table 1 shows these data for December 2006. The largest category is reporting dealers, reflecting the interdealer nature of the market. In any dealer market, dealers rely on interdealer trading to adjust their risk profiles in response to trading flows from end users. According to dealers, Credit Derivatives and Risk Management