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CD and Corp[Orate Treasurer

CD and Corp[Orate Treasurer

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Published by: vijaysai31 on Nov 26, 2010
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10/14/2011

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 The Impact of Credit Derivatives onNon-Financial Corporations
Paper Number: 04/12Paul R. Cox*Mark C. FreemanBrian WrightXfi Centre for Finance & InvestmentUniversity of Exeter
 Abstract
This paper explores the possible use of credit derivatives by corporate treasurers, asan additional tool in their armoury of techniques for risk management. Corporationshave, in recent years, grown comfortable with the idea of using more traditionalderivative products to hedge their exposure to, for example, interest rate and foreignexchange risk. Credit risk, on the other hand, has proven a more difficult animal totame. Whilst avenues for the management of credit risk do exist, for example by theuse of traditional insurance products and letters of credit, such means are not alwaysconvenient. Additionally, insurance companies are themselves now using the creditderivatives market to hedge their exposure to the credit risk of firms.The credit derivatives market is, at present, dominated by large banks and insurancecompanies, who trade credit exposure among themselves. As the credit derivativesmarket becomes more liquid and transparent, this paper asks the question: “Shouldcorporate treasurers consider using credit derivatives to manage their credit risk exposure?” By means of some simple numerical examples, we attempt to illustrate thepossible uses to which corporate treasurers may put such credit instruments. As themarket continues to develop, we anticipate that more and more firms will begin to addcredit derivatives to their list of potential risk-management tools.
*Corresponding author: Paul R Cox, email: P.R.Cox@exeter.ac.uk 
 
The Impact of Credit Derivatives on Non-Financial Corporations
1. Introduction
Corporate treasurers have in recent years grown accustomed to managing variousdimensions of their firms’ risk profiles. The use of derivatives to hedge interest rateand foreign exchange exposure has become a commonplace. Indeed, for multi-national firms, the managing of such exposure is a standard part of their treasuryfunction
1
. One aspect of financial risk that has proven difficult to hedge, however, hasbeen that of the credit risk facing firms. This risk takes many forms. A firm holding alarge portfolio of the bonds of its customers and/or suppliers is clearly exposed tocredit risk. However, such credit risk often takes less readily apparent forms. Forexample, a firm faces sovereign governmental risk when it invests in government-funded projects in newly-emerging economies. A firm is also confronted with creditrisk when it supplies to a customer on standard trade credit terms. Recently, banks andother financial intermediaries have begun to trade credit derivatives to hedge theirexposure to credit risk. Although still developing and changing, the existence andexpansion of such a credit risk market raises interesting possibilities for corporatetreasurers wishing to minimise their exposure to credit risk. This paper examines the rapidly-developing market for credit derivatives, andattempts to answer, through a series of simple examples, the question of whethercorporate treasurers should add credit derivatives to their existing armoury of risk management techniques.
1
 
See, for example, Guay and Kothari (2003).
 2
 
The credit derivatives market is rapidly developing. Taking credit derivatives of alltypes, about $5,000 billion in debt will be protected against default during 2004.Whilst the range of available instruments and their application continues to increase,the market still lacks, at the present writing, the transparency and liquidity of moretraditional, exchange-traded instruments. However, a number of institutional attemptsto standardise the market, for example by the International Swaps and DerivativesAssociation (ISDA) and the emergence of active credit derivative indices such asiBoxx, conceived by a consortium of banks, and Trac-X, launched by Morgan Stanleyand JP Morgan (now managed by Dow Jones), are beginning to fashion the creditderivatives market into a more generally useful form. No attempt is made here toconsider all of the available instruments and applications of credit derivatives for thecorporate user. Rather, we illustrate the potential usefulness of these instruments byfocusing in on two particular kinds of instrument: the Credit Default Swap and theTotal Return Swap.The remainder of the paper is structured as follows.
Section 2
introduces the creditderivatives markets, and considers briefly the main contracts available in the over-the-counter market.
Section 3
looks at the impact of the credit derivatives market on non-financial corporations. In
Section 4
, we consider the use of credit derivatives bycorporate risk managers to manage their external credit risk exposure. This isfollowed up, in
Section 5
, with a consideration of whether managers should trade incredit derivatives written against their
own
companies. They may, for example, wishto purchase credit protection to hedge against receipts from future bond issues, or sellcredit protection to exploit informational asymmetry.
Section 6
presents summaryconclusions.3

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