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Part - V

Credit derivatives have been pitched as an effective way to get around the increasing correlation within the debt and equity markets. "Both U.S. equities and bonds have become increasingly correlated with each other over time," says Mac McQuown, a vice president at San Francisco-based KMV, a credit pricing research and development and software firm. "This means that where 20 or 30 years ago you could reap diversification benefits by holding 50 different equities, today you would require 3,000. A portfolio of U.S. corporate debt, which is even more highly correlated than U.S. equities, might require 30,000 names to achieve a reasonable level of diversification." The solution: using credit derivatives to access an increasingly diverse menu of global exposures to maintain traditional levels of diversification.

Credit derivatives are also being pitched as a new way to generate returns in a post-European Economic and Monetary Union environment. The argument is that EMU will greatly reduce the opportunities for taking on intra-European market risk by providing a common currency and borrowing rate for much of Europe. Now, for example, French and German government bonds are priced differently because of the markets' different perceptions of the two countries' respective interest rates and currencies. But in the post-EMU landscape, any pricing difference between those two bonds would be entirely a result of the relative perception of the two countries' credit risk.

Finally, credit derivatives are continuing to win converts en masse among investors in emerging markets. "In the emerging markets, the next stage of development will include credit derivatives based on domestic instruments," says Oka Usi, global head of credit and emerging markets derivatives at BZW. "For example, credit derivatives might allow an investor to gain exposure to a peso-denominated bond issued by a Mexican company while laying off the associated currency or local interest rate risk."

Nagging problems

Liquidity, however, remains a serious problem for most participants. "It is very difficult to do a credit deal of large size," says one portfolio manager for a large global bank. "Typically, the biggest deal you can do is around $25 million to $50 million. I believe that we need to see a more robust interdealer market for credit derivatives to take off."

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