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While this is better than storing credit derivatives in your desk drawer, it is not ideal. If the underlying asset associated with your credit derivative is, in fact, a corporate bond, then your risk analyses may suffer from inaccuracies because of basis risk, or the difference in how the bond and its corresponding credit instrument are priced. If your reference credit is something other than a corporate bond, then you basically have oranges residing in a system designed to make apple pie.

Ironically, the credit derivatives market is building itself up into one of the most quiescent credit markets in recent memory. The current low premiums for credit risk, in fact, seem to be keeping a lid on growth in credit products. "Because we haven't seen any big credit events, potential hedgers are not necessarily putting credit risk management at the top of their list," says one New York-based broker, "and, because spreads are historically low, some investors may be holding out for more volatility."

While they watch their market bulk up, some dealers quietly admit they are waiting for another twist in the credit cycle-a time when credit spreads were on the upswing and a big credit disaster or two caused investors to pay more attention to the credit risks in their portfolios.

If history is any indication, the golden age of credit derivatives may be just around the corner.

Some Common Credit Derivatives

Credit default swaps: Credit default swaps are analogous to letters of credit. On the "fixed" leg of the swap, the counterparty that is buying credit protection agrees to pay a periodic fixed payment over the life of the swap. In return, the counterparty who is selling credit protection agrees to make a conditional payment should the agreed-upon "reference credit" default or experience some other mutually agreed-upon credit event. This is the "floating" leg of the swap. The reference credit is typically a corporation or some other entity to which the buyer of credit protection has some sort of exposure.

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* Contributed by -
Prashant Jadhav,
2nd Year PGeMBA (Finance),
Mumbai Educational Trust (MET) Schools of Management, Mumbai.