Credit derivatives, though a nascent debt instrument, has grown steadily in spite of turbulent economic conditions. Despite the Enron debacle and the Argentine debt default having posed threats to the industry, the market is efficient enough to absorb the shock.

At a time when debt defaults are the order of the day and the world is perplexed with escalating debt burden, credit derivatives often pass through hard times. However, for corporates, households and governments, neck-deep into excessive borrowings, these instruments appear as knights in shining armors. Credit derivatives are instruments designed to protect the lenders against the default risk of the borrower by a third party called the reference entity. When a company is exposed to a credit default risk, it can reduce it by buying these derivatives while keeping the original debt on its books. These derivatives are private and hence confidential contracts that allow companies to purchase credit protection in a flexible way.

Over the past few years, credit derivatives market has gained momentum at a remarkable pace and has emerged as a new weapon of credit risk management. Since 1997, its growth rate has doubled every year totaling to a whopping $ 700 bn. It is expected to reach a value of $ 1581 bn by the end of 2002, a nine-fold increase since 1997 according to the British Bankers' Association.

The growth of credit derivatives came out of a need and its demand was derived from the uncertainty in the business world. In the early 1990s, when banks were desperately looking for an instrument to hedge their credit risk associated with their loans and interest rates without selling or transferring the underlying assets, these instruments offered a solution. Following a sophisticated mechanism, they played an important role in designing products that could isolate and transfer credit risk in a flexible yet efficient manner.

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