Credit risk management: The use of credit derivatives by non‐financial corporations

Abstract

Purpose

This paper aims to explore the possible use of credit derivatives by corporate treasurers. Corporations have, in recent years, grown comfortable with the idea of using traditional derivative products to hedge their exposure to, for example, interest rate and foreign exchange risk. Credit risk, on the other hand, has proven a more difficult animal to tame. Whilst avenues for the management of credit risk do exist, for example, by the use of traditional insurance products and letters of credit, such means are not always convenient.

Design/methodology/approach

In this paper, both the academic and practitioner literature on credit derivatives and their application are reviewed. Then, by means of some simple numerical examples, the possible uses to which corporate treasurers might put credit default swaps and total return swaps are illustrated.

Findings

The credit derivatives market is, at present, dominated by large banks and insurance companies who trade credit exposure among themselves. As the credit derivatives market becomes more liquid and transparent, it is asked: “Should corporate treasurers consider using credit derivatives to manage their credit risk exposure?” A number of simple and practical ways in which corporations can use credit derivatives to manage risk are explored and the practical strengths and weaknesses of following such approaches are emphasised.

Originality/value

This paper is of particular value to corporate treasurers. This is one of the first academic papers to consider credit derivatives from a financial management perspective.

Citation

Freeman, M.C., Cox, P.R. and Wright, B. (2006), "Credit risk management: The use of credit derivatives by non‐financial corporations", Managerial Finance, Vol. 32 No. 9, pp. 761-773. https://doi.org/10.1108/03074350610681952