Credit Default Swaps Lead to Risk Management Challenge

With the growth of instruments such as credit default swaps and collateralized debt obligations, the marketplace for financial products has become rather complicated. "It has put some significant strains on systems that were built in the late 80s and early 90s," says Gregg Berman, head of institutional business at RiskMetrics Group (New York).

Credit default swaps (CDS) provide lenders with a technique for off-loading the risk that a specific borrower enters when in financial distress. As with commodities traders who rarely lay hands on a barrel of wheat or a pork belly, CDS traders get involved in the financial instrument without having a stake in the underlying asset. "The CDS market is even more liquid than the bonds that they're trading," Berman says. "Now, you can have one entity buy credit protection and another sell credit protection for a name that they have nothing to do with."

These 21st-century financial instruments pose a new risk management challenge. Credit default swaps are exposed to both market risk and credit risk, but banks had typically measured their credit risk exposures on one system and market risk exposures on another.

The challenge has been to integrate the two systems. Toward that end, RiskMetrics Group has developed its CreditGrades methodology for measuring equity-based default probabilities, now endorsed by Deutsche Bank, Goldman Sachs and JPMorgan. The CreditGrades formula calculates the survival probability of a given company by looking at market-observable parameters such as stock price, stock volatility and debt-per-share.

By having a benchmark that indicates the level of default risk at a given company, banks can uncover instances where the credit markets and the equity markets differ on their outlooks. "You need to make sure that the way you measure the risk of your CDS is in line with the way you're measuring the risk of your other instruments, especially if you've purchased CDSs to hedge or arbitrage out another risk," notes Berman.

RiskMetrics Group provides CreditGrades scores via an online subscription service, and has also published the methodology for anyone to adopt on their own.