Credit Derivatives- Part I

"The news hit stocks and knocked jittery credit markets hard, with the widely watched iTraxx Crossover index breaking above 600 basis points for the first time, a reflection of soaring debt-insurance cost" - Reuters
"Credit risk measure the change in the credit quality that have the potential for creating losses resulting in stress in systemtically important financial institutions". Derivative is a risk shifting agreement, the value of which is derived from the underlying asset. The underlying asset can be anything you value, which could be physical commodity, an interest rate, a company's stock, a stock index, a currency, or virtually any other tradable instrument.
The reason we go about analyzing this is because of the credit concerns now extend beyond the subprime crisis. One way this is becoming increasingly evident is through the pressure on the balance sheets of financial institutions. What began as deterioration in credit quality altered the market liquidity and this altered various credit products valuation as people added more risk component in the short term. The credit worthiness of customers and the lending rates of the financial institutions are under distress. The question is what is the way forward?
Although the economic condition is adding to the distress, most of it is mitigated by the efforts of the central bank to instigate spending. There should be other ways of improving this situation.
This situation is not just for European or American markets, but it extends to markets like India, where we witnessed some adverse fallout since the starting of this year, a spillover effect.
This has lead to tighter economic and monetary policies which could curtail economic activity further. Falling equity prices will exacerbate the reduced consumer spending. And finally, capital spending could be reduced as the cost of capital increases.

What is interesting is the way the emerging markets are responding to these global cues. High inflation which is as high as 7% in India for example will have to go down as the global economy shrinks. What about the equity inflows in India? According to the recent study on equity inflows in emerging markets by Bank of New York goes against conventional wisdom. It find little to no net effect of inflows on equity prices. But definitely there is a significant relation between the inflows and the equity prices in India at least in the short term.

In the subsequent article we will see how credit is managed and what are various credit derivative products that are available.