Introduction

Abstract

Recent surveys of derivatives usage in non-financial firms underline the fact that derivatives play a prominent role in financial risk management.¹ Nonfinancial firms generally prefer privately negotiated over-the-counter (OTC) derivatives to exchange-traded contracts.² OTC derivatives allow the parties to tailor the terms of the contracts to suit their desired risk profiles. A major disadvantage of OTC products over exchange-traded products is that parties are exposed to default risk,³ that is, the risk that the respective counterparty will default on its obligations. Some large-scale corporate financial crises in the 1990s that were triggered by arguably questionable derivatives strategies have highlighted the importance of managing the credit risk of derivatives.⁴ This raises at least two important questions: first, which tools can be used to mitigate the credit risk of OTC derivatives; second, how the credit risk of derivatives or even entire portfolios can be priced in order that the holders are adequately compensated for the risks they bear. Clearly, the two problems are interrelated, because any contractual agreement between parties which reduces credit risk will influence the default risk premium reflecting the parties’ relative credit quality.