Bankers who think that credit derivatives give them risk protection may find themselves on the wrong end of market mispricing. Natasha de Teran reports. For some while now the world’s leading banks have been seen as the villains of the credit derivatives (CDs) markets. They parcel up their poorly performing assets, it is claimed, and sell them on to unsuspecting investors. Then, when a credit blows up – Enron, Worldcom, Parmalat – it is the insurance companies and other investors that take the hit and not the banks, complain critics. It is great for the world financial system as bank collapses are avoided. But dreadful for shareholders and buyers of with-profits policies from insurance firms whose returns are ruined.
The trend for cross-asset trading has spawned a new product, equity default swaps. Supporters are championing their advantages but, says Natasha de Teran, it is likely that EDSs will have to jump through a few more hoops before take-up is widespread.For some banks the fall in equity prices and the demise of the dot.com-fuelled equity investing culture happily coincided with an increased focus on credit risk management and the fast development of the credit markets. Those that managed to gain a lead in the rapidly growing credit sphere have reaped the rewards.