Credit Derivatives in Managing Off Balance Sheet Risks by Banks

 COPYRIGHT MURAT ÇAKIR Central Bank of the Republic of Turkey. All rights reserved. No part of this work may be reproduced, stored in a retrieval system, transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except formal use of reference to the author without the written permission thereof 6 I. INTRODUCTION Banks and other non-bank financial institutions are today’s most complicated economic units. Their overall portfolios are more so... The management of these portfolios is one of the greatest challenges facing the financial manager. With the introduction of credit derivatives and mechanisms that allow institutions to un- bundle the credit risk (CR) portion of traditional debt instruments from market risk (in an effort to improve pricing efficiency), this challenge could have been better and more easily handled in the last decade. The goal of a portfolio manager—regardless of whether the portfolio is composed of equities or credit assets—should be to create an “efficient” portfolio. With equities, the manager can usually buy and sell assets until he attains the optimal level of diversification. However, the manager of a loan portfolio typically faces several constraints and conflicting objectives while managing this portfolio. For example, some of the loans in the portfolio may be liquid, and those that are may not be truly saleable because of restrictions in the documentation or the effect of a sale on the relationship with the borrower(s). Credit derivatives (CDs) provide loan portfolio managers with a number of ways of constructing and shaping a portfolio and managing the conflicting objectives they have to face on both micro and macro levels. Firstly, CDs can be used to reduce the portfolio’s exposure to specific borrowers (obligors) or to diversify the portfolio by synthetically accepting CR from different industries or geographic regions that were previously under-weighted in the portfolio, on the micro level. On the macro level, CDs can be used to create “synthetic” securitized positions that alter the risk and return characteristics of a large number of exposures at once. The development of CDs is a logical extension of two of the most significant developments of the recent past: securitization and derivatives. The concept of derivative is to create a contract that derives from an original contract or asset. For example, stock market derivatives are contracts that are settled based on