The effectiveness of credit derivatives on bank portfolio management: An empirical analysis

This dissertation investigates the relationship between credit derivatives and bank portfolio performance. It was estimated that the global credit derivatives market would reach {dollar}4.8 trillion notional amount by the end of 2004. This represents an explosive 27-fold growth in the seven years from 1997 to 2004. The impact of credit derivatives on bank portfolio management could be substantial because banks are natural credit risk takers. The majority of bank assets are illiquid and indivisible. Risk diversification for bank portfolios is rather difficult. Credit derivatives allow banks to hedge their undiversified credit risk or obtain desirable credit risk exposure without balance-sheet funding, and therefore, improve bank portfolios' return-risk structure.; Panel data models are employed to test the impact of credit derivatives on 38 large US banks with minimum {dollar}10 billion assets over the period 1997--2002. Although no evidence is found that credit derivatives are positively correlated with bank portfolio performance for the whole period, banks with credit derivatives activities significantly perform better than other banks in the later period 2000--2002 which witnesses an economic recession and an improved liquidity of the credit derivatives market. It suggests that banks will be more likely to be better off with credit derivatives when the credit derivatives market becomes mare mature. Moral hazard is also observed and could be one of the reasons for the overall insignificant relationship between credit derivatives and bank portfolio performance.