Credit Portfolio Management

This chapter explains how credit portfolio management techniques, notably credit derivatives, help customizing the needs of both bankers and investors by trading separately the credit risk component of assets. It discusses several areas and illustrates them with a simplified case study.

• Active portfolio management: credit derivatives provide all the features necessary for actively reshaping the risk-return profile of a portfolio. Securitization techniques previously discussed are also within the scope of portfolio and capital management.

• Hedging credit risk: hedges result from matching asset credit risk with the mirror credit risk of a credit derivative. In addition, credit derivative hedges apply to single assets, baskets of assets, or the entire bank's portfolio.

• Creating synthetic exposures and taking credit exposures: the seller of a credit derivative can take synthetic exposures that would, otherwise, be out of their direct reach. Selling a credit default swap is a substitute to taking cash credit exposure. On the other side of the deal, the lender hedges its risks.

Section 59.1 expands the rationale for active credit portfolio management. Section 59.2 is a reminder of the techniques for trading credit risk. Section 59.3 discusses applications of credit derivatives. Section 59.4 illustrates, through an example, how credit derivatives can serve for enhancing the risk-return profile of a portfolio, through regulatory arbitrage. The last section (Section 59.5) generalizes the principle of taking advantage of discrepancies between the prices of the same risk. For banks, the price of credit risk is capital-based. For investors, the price is rating-based. Both capital-based and rating-based prices of a given credit risk will generally differ, leading to profitable arbitrage between the two prices.