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Part - VIII

Some gray areas remain, however. Many insurance companies, which in theory could use credit structures to mitigate their risk associated with investments they are required by law to hold to maturity, are holding off on entering the credit markets until insurance-specific regulations address credit derivatives. Likewise, Masters explains that the Bank of International Settlements has yet to provide a clear statement on how credit derivatives might mitigate European banks' credit-related capital charges.

In an effort to preempt the regulators and create an industry-wide standard for the measurement of credit risk, JP Morgan has released CreditMetrics (See Derivatives Strategy, May, p. 6), which takes a Value-at-Risk approach to determining portfolio-wide risk associated with credit. In an unusual show of cooperation, JP Morgan has recruited other dealers-including BZW, Deutsche Morgan Grenfell, Swiss Bank Corp., the Union Bank of Switzerland and the Bank of Montreal-to help distribute CreditMetrics. The common goal is to set an industry-wide benchmark for credit risk and thus raise market participants' comfort level with credit structures.

The development of sophisticated, quantitative credit risk management at an increasing number of banks is another prerequisite for continued growth in the credit derivatives markets. This makes intuitive sense. After all, financial institutions need to be able to pinpoint their credit risks in order to be able to take advantage of hedging opportunities in the credit derivatives markets.

Price fight

Another deficit in today's credit markets is the lack of an industry-standard pricing model for credit. "Most traders today do not use a model to price credit derivatives," says ICAP's Crammond. "Instead, they look at the price of the underlying asset to provide an estimate." Some dealers argue that this "guestimation" method does, in fact, provide a useful indication of where credit derivatives may be priced. "One of the challenges for dealers will be to effectively price credit derivatives based on debt instruments for which there is little available public information," notes BZW's Usi. But the extent to which pricing models are a "must have" for participation in the credit derivatives market is the subject for a considerable debate, often fogged by self-interest.

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