Question

Critically discuss whether you would agree with the following statements:

i. Banks use credit derivatives more for credit risk management than trading
activities.

ii. “AIG’s collapse was caused largely by its $527 billion portfolio of credit default
swaps (CDSs)…” (Sjostrom, 2009, p. 945).

Answer 1

1. This statement is correct. The downside of Trading activity is that id adds risk at times. However, banks use credit derivatives to transfer part or whole of its credit risk arising from loans lent to another party. Thus, Credit derivatives are tools enable banks to handle the avenue of credit risks more efficiently than Trading activities.

2. The statement is correct. AIG collapsed largely due to the Credit Default Swaps which amounted to about $ 526 bn. These CDS are credit derivatives widely used by Financial Institutions which remain unknown to the public. AIG issued CDS securities to banks and other institutions against the bonds which were then defaulted. Thus AIG remained with practically no money to repay ending up into major fall down.