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Wednesday, July 27, 2005

Credit Derivatives and Systemic Risk (from the WSJ)

Today's Wall Street Journal has a very interesting piece on the increase in systemic risk over the last few years. It discusses how systemic risk has increased over time as a result of several factors like the increased popularity of hedge funds and derivatives (particularly credit derivatives):
...The Counterparty Risk Management Group II is a revival of a group that was formed in 1999, following the implosion of hedge fund Long-Term Capital Management, to consider risks in the financial system.

The group, under its chairman E. Gerald Corrigan, reconvened several months ago, spurred into action by the rise of hedge funds and the increasingly complex nature of trading and risk-taking in the markets. Gyrations in the credit markets earlier this year have heightened interest in the group's work.

"Credit is at the core of what they are looking at," says Bradley Ziff, head of the hedge-fund practice at consultancy Mercer Oliver Wyman, who worked closely with the group. "And all that has happened in the credit markets in May vindicates their concerns. Credit products have dramatically changed the marketplace."

The most compelling evidence of that transformation came in mid-May, when a ratings downgrade of General Motors Corp. corporate debt roiled both the corporate-credit and various derivatives markets. The large, unanticipated moves in these markets led to trading losses both among funds and the dealers with whom they trade. Even though the markets recovered quickly, that episode raised concerns about the risk involved when so many players engage in similar trading strategies and positions become hard to close out without a massive move in prices.

Click here for the whole thing (online subscription required).

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