what are credit derivatives and which exchangs use these tools extensively?

Question

There had been these buzz about credit derivatives,how does it work and where can one use them.

Answer 1

Wikipedia actually does a pretty good job describing them...

http://en.wikipedia.org/wiki/Credit_derivative

Now there has been lots of buzz because there are trillions of dollars of US-based credit derivatives outstanding. The buzz is because of systemic risk. That is, if the economy turns sour quickly, the default rates will risk putting a significant part of the speculative end value at zero. If a hedge fund has levered up and has significant exposure to them, there is chance that significant economic downturn can cause the hedge fund to implode - causing another "Amaranth".

In terms of how do you use them? You, as a mere mortal, almost certainly can't. Credit Derivatives are non-standardized "over-the-counter" securities. That is, you are buying a specific credit risk (or bundle of credit risks) specific to the underlying security (e.g. someone's chances of defaulting on a loan). Since they are non-standardized - they are not listed on any exchange.

You can go long or short on them, but you are going to need lots of capital to get started, a way to access the closed market (e.g. you are a bank, a hedge fund with connections) and a working knowledge to keep from losing your shirt.

They are primarily used as a hedging tool for the natural long position on credit securities (e.g. the bank). The bank then packages the loans, splits the loan into different risk tranches (e.g. Z-tranche). In this case, a bank would want to sell off the Z-tranche (the tranche left holding the bag if the loanee defaults) to lower their credit risk.

Credit derivatives are also used as speculative investments. Investors can buy tranches that are priced attractively, seeking to pick up the profit differential between (for example) the cash flows received net of defaults and the price paid (which has an implied default rate).

Answer 2

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