The Federal Reserve Board eagle logo links to home page
Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page Credit Derivatives in Banking: Useful Tools for Managing Risk?
Gregory R. Duffee and Chunsheng Zhou

Abstract: We model the effects on banks of the introduction of a market for credit derivatives--in particular, credit default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans would trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the ``lemons'' problem caused by banks' superior information about the credit quality of their loans. However, we find that the introduction of a credit derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down. In this case, the existence of a credit derivatives market will lead to a greater risk of bank insolvency.

Keywords: Credit default swaps, bank loans, loan sales, asymmetric information

Full paper (190 KB PDF) | Full paper (202 KB Postscript)

Home | Economic research and data | FR working papers | FEDS | 1997 FEDS papers
To comment on this site, please fill out our feedback form.
Last update: July 16, 1997