Lars Nyberg: Credit derivatives – risks and opportunities Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at a meeting at StartegiTorget Bank, Finans & Försäkring, Stockholm, 13 March 2007. *  *  *  Let me begin by thanking you for the invitation to come here and speak about the risks and opportunities offered by credit derivatives. Credit derivatives may appear complicated, but the principles as to how they work are essentially simple. They are a type of insurance, nothing else. A person who owns a house runs the risk that the house may burn down. A person lending money runs the risk that the borrower will not pay back the loan. The house-owner usually wants to sign a home insurance policy covering the risk of fire and is happy to pay a premium for this. The bank lending money may correspondingly – although banks are actually specialised in managing credit risk – wish to sign a credit insurance to dispose of the credit risk, wholly or partly. The bank then also has to pay an insurance premium. A credit derivative is quite simply a modern form of credit insurance, adapted for trade in the financial markets. Trade in credit derivatives has expanded enormously in recent years, which of course implies that credit derivatives offer advantages to their users. At the same time, a debate on the potential risks for the financial system has arisen and interest from the supervisory authorities and central banks has increased.
BIS Review 24/2007  Underlying assets The underlying assets largely consist of corporate bonds; these account for around 80 per cent. However, there are other types of credit, such as traditional bank loans and various forms of sovereign debt. The corporate bonds market currently covers more than USD 6,000 billion in global terms. This means that the outstanding volume in credit derivatives is more than twice as large as the total amount of outstanding corporate bonds. The reason for this is that credit risks are resold on the market through new derivative contracts. This is not actually any stranger than insurance companies selling part of their risks by reinsuring themselves, but it may be good to bear this in mind when looking at the statistics. Today, credit risk is priced on thousands of corporate credits through credit derivatives, although most of the trade is still in a few hundred very large companies. Companies in all types of industries and with different credit ratings are traded. Communication, such as the example of TeliaSonera, is one of the most traded sectors, together with the automobile industry and finance. The credit quality of the underlying bonds is generally very high. But appetite is increasing for underlying assets with low credit ratings. The standardised maturities have also increased in number with time and there is a tendency for longer maturities, five to ten years, to be traded more.