Wednesday, July 18, 2007

Risk of credit default

Investors in some structured products are taking the risk of credit default. If a "credit event" happens, they may lose a substantial or all of their principal.

What is the risk of this happening?

The issuer said "We have issued similar products in recent years, and none have not defaulted".

I studied a report from a credit rating agency on the default rates in past years:

* For the past two years, the default rate is small. It is at a historical low level, due mainly to the booming global economy.

* Looking at a longer period, the default rate is higher. It is still small, but not that small.

As the structured products are issued for 5 to 6 years, the risk of a global downturn is "not small". This could lead to a higher default rate.

Lesson: Do not take this risk (as you may not be adequately compensated for it). If things turn bad, you may be in for a big surprise. By that time, you cannot reverse your decision.

1 comment:

Anonymous said...

There's something I don't understand. Instead of incurring the cost of the swap and betting on such few credit references, why not just buy a well-diversified low-cost bond fund of the same credit rating (each of which can probably give approximately the same yield) ?

It's not as if I can't use the well-proven technique of diversification. I can understand the value of swap hedge for companies --- like a bank which offers loan on a case-by-case basis, or a company which needs specific natural resources like oil.

What can swaps do (for private investors) that diversification can't?

Blog Archive