Credit Derivatives , Macro Risks , and Systemic Risks

E C O N O M I C R E V I E W Fourth Quarter 2007 In the early to mid-1990s, derivatives received a great deal of negative publicity in the popular media. Several unfortunate incidents ultimately led Gastineau and Kritzman (1996), in the revised edition of their Dictionary of Financial Risk Management, to define a derivative as, “in the financial press, anything that loses money.” The proximate causes of these derivatives disasters were a variety of factors: Metalgesellschaft experienced a cash flow mismatch between long-term over-thecounter (OTC) forward contracts and marked-to-market short-term exchange-traded futures; Gibson Greeting was encouraged to enter into complex, and probably inappropriate, financial transactions that it apparently didn’t fully understand; Procter & Gamble and Robert Citron of Orange County assumed significant investment risk, exacerbated by a “surprise” interest rate hike; Barings Bank employed a rogue trader who was able to engage in fraud because of the lack of institutional risk control; and, of course, just about everything went wrong at Long-Term Capital Management (LTCM). Many of these incidents were highlighted prominently soon thereafter in books with titles such as Derivatives: The Wild Beast of Finance (Steinherr 1998). At least one market participant (an investment bank) felt that the label “derivatives” was so detrimental that it renamed its offerings “risk management products.” Many remain skeptical of the value that derivatives can provide; one hedge fund manager, speaking to a group of summer MBA interns at an investment bank in New York a couple of years ago, when asked if he used options as part of his investment strategy, replied, “I don’t go to that crack house.” The (interest rate) swap market has been around for only about twenty-five years, yet it is one of the largest and, arguably, one of the most important and successful financial markets in the world. Credit derivatives are much newer, having been first publicly introduced by the International Swaps and Derivatives Association (ISDA) in 1992 but not broadly traded until after the standardization of the documentation in 1999. Credit Derivatives, Macro Risks, and Systemic Risks