Date of Award

4-28-2008

Document Type

Thesis

Degree Name

Bachelor of Arts

Department

Economics

First Advisor

Dr. Robert Dolan

Abstract

Recent developments in credit markets over the past few months have seen credit spreads widen dramatically for a range of debt products. Almost overnight, credit spreads for both investment grade and high yield bonds jumped as news continued to worsen about credit quality. The speed with which credit spreads increased this past summer led many investors to ask if markets were efficient in conveying material information, and to see if there were any indications prior to the credit crunch that the market for credit was going to tighten. New products such as credit derivatives have increased the number of indicators investors can use to evaluate markets and subsequently increase the efficiency of these markets. However, credit derivative products are relatively new and have only recently begun to be traded extensively, thus it is yet to be seen how efficient the market for credit derivatives is and whether they can be used to anticipate credit events.

The relatively young age of credit derivatives means that there are still many things to be determined about their nature in the financial markets. Their effects may not be fully comprehended, but the market has embraced their use, as there are over $62 trillion dollars worth of notational credit derivatives outstanding today. This is more than half of the real assets in the world. Credit default swaps may seem to be a great way to diversify risk away and distribute it across the financial system, but they actually amplify risk. For example, if Ford issues one billion dollars worth of bonds and defaults with a recovery rate of 40%, $600 million dollars will be lost in the cash market. However, ten billion dollars worth of credit default swaps could be written on Ford and could amount to losses of over three billion dollars.

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