Application of credit default swaps to commercial banks

Abstract

Commercial banks contribute significantly to the growth ofa nation's economy. The profitability of commercial banks is largely attributed to the interest charged on loans they advance to their customers. If these loans are defaulted, banks face the risk of collapsing and the entire economy will be threatened. Banks use credit derivatives to protect themselves against credit risk arising from loan defaulters. Loan defaulting has been and continues to be a cause of financial distress in the banking sector both locally as well as globally. More efficient approaches of managing credit risk need to be looked into. In this study, the application of credit default swaps as a credit risk management tool in the banking sector is looked at. Credit default swaps are shown to effectively transfer risk from commercial banks to insurance companies. Data relating to loan facilities sought by individual companies was collected from a local commercial bank. Additional data relating to treasury and corporate bonds was collected from the Nairobi Stock Exchange. Data was analyzed using the Hull-White Model of credit default swap valuation. The study shows that commercial banks are able to manage their credit risk efficiently using credit default swaps. From the data analysis, the results show that by paying a premium of 513 basis points per year for a credit default swap contract, a potential loss of up to Kshs. 17,291,275.61 is avoided. This shows that by using credit derivatives, the profitability of a commercial bank is increased as large sums of money that would otherwise have been lost to loan defaulters is put into other income generating activities.