No replacement risk if counterparty backs out

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no replacement risk if counterparty backs out Property swap advantages- o OTC: more specific instruments, tailored to specific values of property, i.e. property in a specific location risk is relatively stable, doesn’t change too much? o Exchange: liquid, easier to close or change risk theoretically cheaper easier to find counterparty ** OTC is swaps- provide better hedges but are more expensive, less liquid and have replacement risk **Exchange is futures and options- more liquid, less expensive, no replacement risk, easy to open and close position and easy to enter 2. Why have credit derivatives done so well? What is their economic function? Are there alternative ways of performing this function? What is the advantages of derivatives? How might they compete with interest-rate swaps? Why working- o high trade volume o Getting even better because an increase in standardization o New products are being created that are based on credit derivatives o Financial engineering allows investors with different risk preferences to participate Economic function- o better risk management, allows for unbundling of financial risks. o credit derivatives spread the burden of the defaults across a broad group of banks and other institutions Alternative ways of performing function- o futures contract, or option contract betting on default or repayment of loan Advantage of derivatives- o Risk management o Property swap: swapping out the risk that property values go down o Credit swap: separating credit risk Competing with interest-rate swaps- o They don’t, they’re for different risks ** Credit derivative- a type of derivative in which the risk that a loan will not be repaid is sold to a party other than the lender 3. Why is there concern about the heavy participation of hedge funds?
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Inexperience (might increase counterparty risk - the danger that a seller of credit protection cannot pay in the event of a default) and high leverage Using in inappropriate ways - o Instead of being used as a speculative investment, CDS have often been purchased to hedge portfolios of other securities that funds currently own Probably not concern because skin in the game ** Hedge fund- a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains. 4. How are property derivatives like credit derivatives? What are the differences that make them more problematic? Both involve some transfer of risk o Credit - transfer risk of borrower defaulting on loan o Property - transfer risk of fall of property price (asset value) o Both are wagers Property: o Lacks liquidity (so few derivatives have been issued) o Property has been very profitable and prices are rising, difficult to find people willing to sell property derivatives o Lack of volume means not yet possible to peel off sub-sectors (e.g.
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