Document Type

Article

Publication Date

2014

Keywords

derivatives, hedging, financial regulation, Dodd-Frank Act

Abstract

Is hedging with credit derivatives always beneficial? The benefit of hedging with credit derivatives, such as credit default swaps, is presumed by the Dodd-Frank Act, which excludes hedge transactions from much of the new financial regulation. Yet, significant new risks can arise when credit derivatives are used to manage risks. Hedging, therefore, should be defined not only in relation to whether a transaction offsets risks, but also whether, on balance, the risks that are mitigated—as well as any new risks that arise—are outweighed by the potential benefits.

Regulators of the derivatives markets must consider the risks of hedging with credit derivatives and the inability of firms to account for those risks, as well as the value to firms of mitigating risks with credit derivatives and the costs arising from their use. Among other proscriptions, the types of credit derivatives transactions that can be classified as a hedge should be limited, as well as the size of those positions. In addition, margin and collateral requirements for credit derivatives should take account of the greater risks arising from their use.

Firms using credit derivatives to hedge often fail to account for the full costs associated with using those instruments. There are numerous risks that can arise. Informational asymmetries and negative externalities, however, make it difficult for firms to accurately assess those risks. Consequently, the far-reaching exemptions for hedge activity provided by the Dodd-Frank Act are inappropriate. Credit derivative hedges must be subject to regulatory oversight, rather than exemption

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Library of Congress Subject Headings

Financial risk management, Hedging (Finance), Credit derivatives, Derivative securities

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