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Few events have stimulated international capital market activity as much as the development of derivative securities. Derivatives, which include futures and options, are contracts whose values reflect changes in the price of underlying assets such as stocks, bonds, commodities, or foreign currency. Swaps, which are over-the-counter instruments involving the exchange of one stream of payment liability for another, are presented, including credit default swaps and collateralized debt obligations. Derivatives are intended as a tool to manage the various risks associated with financial assets and liabilities, the market values of which can fluctuate widely. However, derivatives tend to be complicated, and understanding the full spectrum of their risks can be difficult. During financial turmoil, the risks can become exaggerated, as evidenced by the part they played in the global financial crisis that began in 2007.

For bonds and other financial contracts issued by some firms and countries, there is a non-negligible risk that the issuer will default and the holder of the contract will not receive the promised payments. The prices of the contracts will reflect that credit risk. This chapter introduces various key concepts and relations used in the markets for defaultable bonds. The two main modelling frameworks — the structural models and the reduced-form models — are presented with several concrete models studied in detail. The characteristics and possible pricing techniques for the most important credit derivative securities — credit default swaps and collateralized debt obligations — are also explained.

Based on the importance of CDS, Mehrling argues in his chapter that the current crisis is best seen as the first test of the new system of structured finance. That test has revealed the crucial role played by credit insurance of various kinds, including CDS, for supporting both valuation and liquidity of even the top tranches of structured finance products. The various government interventions of the last year amount, in his view, to the public sector going into the credit insurance business in response to crisis—by either writing credit insurance or taking over insurance contracts written by others. The author calls this the “Paulson‐Bernanke CDS put.” In his view, a basic lesson of the crisis is that the government must be in the credit insurance business in normal times as well.

This chapter looks at the different types of swaps, including plain vanilla interest rate swaps, in which counterparties exchange fixed-rate risk for floating rate risk, and currency swaps, which can be foreign exchange swaps or foreign currency swaps. It also considers credit-default swaps including their purpose and function and describes the ISDA Master Agreement. In addition, it explains concepts such as credit event and reference entity, along with the impact of the financial crisis on over-the-counter derivatives. The chapter concludes with a discussion of reform in the regulation of financial institutions in the United States in the wake of the financial crisis. This discussion includes an analysis of the MF Global bankruptcy.

A swap is a bilateral over-the-counter derivatives contract in which two parties agree to exchange cash flows on a “notional amount” over a period of time. The notional amount is a reference amount upon which the payment formula is based. The parties exchange cash flows pursuant to an agreed-upon payment schedule, made up of one or more payment dates throughout the life of the contract. Cash flows are computed by applying the agreed-upon formula relating to each party's respective set of payments of the swap to a notional amount, that is, a hypothetical underlying value that does not necessarily itself change hands. This chapter discusses “plain vanilla” interest rate swaps, currency swaps, credit-default swaps, and the move toward regulatory reform.

This chapter discusses how federal regulators contributed to the subprime crisis. Congress laid the groundwork back in 1999 and 2000, when it deregulated over-the-counter credit default swaps, which ultimately became pathways of contagion. The Securities and Exchange Commission (SEC) for its part looked the other way while banks issued droves of subprime bonds and collateralized debt obligations (CDOs) marred by shoddy due diligence, skimpy disclosures, and inflated credit ratings. Then federal banking regulators sealed the financial system's fate by allowing commercial banks to load up on toxic mortgage-backed securities.

This chapter explores various financial instruments and activities. These include hedge funds, derivatives, and credit default swaps. A hedge fund is a legally restricted investment vehicle maneuvered by managers in an attempt to dodge fluctuations in currencies, interest rates, and commodity prices, using over-the-counter derivatives and credit default swaps. Derivatives, while transacted over-the-counter, permit the buying and selling of currencies and stocks, commodities, and securities in private deals rather than openly on a stock exchange. Credit default swaps, as these resemble derivatives, are known for their destabilizing features. Amidst these transactions, rating agencies are tasked with evaluating financial instruments involved in the trade.

Interest rate derivatives markets have enjoyed substantial growth since the late 1990s. This chapter discusses the development of these markets since 2000 and introduces the most popular interest rate derivative instruments. Although forward rate agreements and interest rate swaps are important examples of over-the-counter (OTC) products, futures on interest rates and bonds are innovations of organized exchanges. Both OTC interest rate options and exchange-traded options on interest rate futures are discussed to illustrate an overlapping area of both types of derivatives markets. Participants in debt markets are also exposed to both interest rate and credit risk. To mitigate the latter risk, the OTC fixed income derivatives markets provide credit default swaps (CDSs). As credit derivatives are also a subset of fixed income derivatives, CDSs are discussed further.

Like the credit boom of the 1920s, the toxic credit bubble of the 2000s precipitated a devastating global financial crisis. The desire to earn quick profits from originating and securitizing subprime loans corrupted the risk management practices of large financial conglomerates and the credit review practices of credit ratings agencies that assigned investment ratings to mortgage-related securities. By the end of 2006, U.S. credit markets resembled an inverted pyramid of risk, in which multiple layers of financial bets depended on the performance of high-risk subprime loans held in securitized pools. When housing prices began to fall and subprime loans began to default in large numbers in 2007, the leveraged bets on top of that pyramid of risk blew up and inflicted devastating losses on financial institutions and investors in the U.S. and Europe. Officials on both sides of the Atlantic were slow to recognize and respond to the severity of the crisis. The Federal Reserve Board and the Treasury Department missed multiple warning signs that should have caused them to increase their oversight of major U.S. banks and other large financial institutions during 2007 and early 2008.

This chapter discusses the U.S. and EU regulatory proposals for dealing with the global financial crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act were two of the landmark legislations for overhauling the U.S. regulatory framework. The Dodd Frank proposal sought to address five regulatory issues: (i) the excessive risk taking of financial institutions; (ii) regulatory controls for over-the-counter derivatives and credit default swaps; (iii) the protection of consumers as holders of mortgages and credit cards; (iv) the distribution of regulatory functions among regulatory agencies; and (v) the uniformity and accessibility of global regulatory agencies. In contrast, the regulatory momentum in the EU was slow and dissonant due to the lack of political cohesiveness of nation-states.

This chapter examines how financial innovations and excesses in banking contributed to the financial crisis of 2008. It begins by considering the growth of the banking system, with many firms deciding to put spare cash in very short-term loans to investment banks and hedge funds. It then explains why bank capital fell dramatically and proceeds by discussing the ‘shadow’ banking system as well as structured finance and securitization. It also analyzes derivatives and credit default swaps and how the growing interdependence between bank-like activities and financial market-based activities gave rise to bank liquidity problems. Finally, it looks at the nature of incentives and risk-taking as well as the financial institutions' failures in risk management.

This chapter analyzes the growth of OTC derivatives before the global financial crisis of 2008 and the role of credit default swaps, in particular, in the near collapse of the global economy. It begins by exploring the basic characteristics of derivatives used as risk management instruments by investors to hedge against or exploit the volatility of asset prices. The analysis further reveals that the pre-crisis period was characterized by a broad-based consensus favoring deregulated markets and globally designed private rules. While not always unanimously supported, permissive public regulatory choices were often encouraged by interest group lobbying, the market-friendly views of many domestic authorities, and concerns about regulatory uncertainty and international competitiveness.

This chapter examines the evolution of the structure, conduct, and performance of mortgage markets in the United States. It traces federal interventions in the mortgage markets from the 1930s to the present. These interventions dramatically shaped mortgage markets. The failure of regulators to contain private risk taking in mortgage markets during the 2000s led to excessive leverage and risk. The financial crisis that ensued prompted the federal government to bailout the housing finance system. The chapter concludes with a set of issues raised by the near collapse of mortgage markets. These issues include how to: (1) regulate originators, securitizers and rating agencies; (2) protect claim hierarchies in first and second mortgages to allow debt restructuring, (3) construct pooling and servicing agreements; (4) regulate credit default swaps (CDS) so that sellers are monitored to ensure they have the capital to honor their commitments; and (5) provide adequate disclosures and protection against interest rate risk as markets soak up low-yielding debt obligations.

This chapter deals with key events in financial markets leading up to the financial crisis of 2008 and around the times when spreads rose dramatically. It examines the key amplification mechanisms at work, which moved restlessly from markets to banks to whole countries and back again, wreaking their own peculiar kinds of havoc. It also considers the problems that affected the housing market in the United States, including the fall in house prices; the collapse of liquidity among banks and other financial institutions; the fall of the Northern Rock bank in the UK; and the collapse of major companies such as Bear Stearns, Lehman Brothers, and AIG. Finally, the chapter analyzes the circumstances that led to the United States's Fannie Mae and Freddie Mac into government conservatorship, the overselling of credit default swaps and its impact on derivatives, and the interaction between market-value accounting standards and capital adequacy regulations based on credit ratings.

This chapter examines leverage as a major cause of asset price bubbles. It outlines four reasons why the most recent leverage cycle was worse than previous cycles. First, leverage reached levels never seen before in previous cycles. Second, there was a double leverage cycle: in securities on the repo market and in real estate in the mortgage market. Third, credit default swaps (CDSs), which had been absent from previous cycles, played a major role in the financial crisis of the late 2000s. Fourth, extremely high leverage and low prices put a much larger number of people and businesses underwater than in earlier cycles. The chapter initially discusses the relationship between leverage and asset pricing before turning to a discussion of models of collateral and debt forgiveness (or punishment for default). It then suggests that collateral and leverage need to be integrated into macro models, and that by taking collateral seriously the effect on asset prices of new derivatives like CDSs can be properly assessed. Finally, it considers the optimal punishment for default and the adverse effects of debt overhang.

The purpose of this chapter is to illustrate the role of syndicated and bonded loans as a source of sovereign financing. This analysis will concentrate on the dynamics of the primary and secondary markets of these debts and the protective clauses reproduced in the loan agreements, with particular reference to the problems originated by a controversial interpretation of the pari passu clause.

High yield bonds (HYBs) have become an integral part of the funding and investment landscape. HYBs are bonds rated below investment grade, indicating a potentially greater default risk and concomitant return. Although often associated with leveraged buyouts (LBOs), corporations also use HYBs to finance general corporate needs. The key drivers of HYB issuance include general economic activity, the number and size of transactions requiring financing, interest rates, and the availability of substitute financial products such as leveraged loans. Leveraged loans are another source of financing for issuers with a similar profile as HYB issuers. A key difference between HYBs and leveraged loans is that the covenants associated with a leveraged loan are typically more lender friendly. Similar to investment grade bonds, investors can purchase insurance to hedge a long HYB position against a credit event by using a credit default swap.