Credit Derivatives and Commercial Banks’ Risk Management

This paper illustrates the value of credit derivatives with two examples. A commercial bank can use credit derivatives to manage the risk of its loan portfolio. However, credit derivatives pose risk management challenges of their own. This paper discusses five of these challenges. Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. They can create counterparty credit risk that itself must be managed. Complex credit derivatives rely on complex models, leading to model risk. The settlement of a credit derivative contract following a default can have its own complications, creating settlement risk. For the credit derivatives market to continue its rapid growth, commercial banks must meet these risk management challenges.