Credit Risk Management pp 159-239 | Cite as

# Credit Derivatives and Counterparty Credit Risk

## Abstract

Financial derivatives are generally contracts whose financial payoffs depend on the prices of certain underlying assets. The contracts are traded Over the Counter (OTC), or in a standardized form on organized exchanges. The most popular derivative types are forwards, futures, options, and swaps. The underlying assets are, typically, interest rate instruments, stocks, foreign currencies, or commodities. The reasons for entering into a derivative contract might be hedging, speculation, or arbitrage. Compared to on-balance sheet instruments, derivatives allow investors and other market participants to hedge their existing positions, or to enter into new exposures with no, or very low, initial investment. This is an advantage in the case of hedging, but at the same time, in the case of a speculation, a danger, since large risks could be taken too easily. Derivatives are sometimes compared to electricity; something that is very useful if properly used, but extremely dangerous if used irresponsibly. In spite of those warnings, the derivatives market has grown tremendously in recent decades, with OTC outstanding notional amounts exceeding 650 trillion USD, as of the end of 2014, and exchange traded derivatives’ annual turnover exceeding 1450 trillion USD in 2014.

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