Credit Default Swaps, the precocious brain-child of financial engineers is just about ten years old and has not only caused enough ripples in the financial services market to draw the attention of all but has also become the cynosure of all eyes. The advantage of having financial brain-children lies not only in their becoming earning members but also their fecundity even at a very young age. When child prodigies are pampered and bestowed too much of attention, they do throw tantrums. Without extending this analogy too far, this article takes a closer look and briefly deals with the introduction into the market of new credit derivative products and applications, issues of valuation, documentation, settlement and present state of the market. In conclusion, the article gives a perspective on credit derivatives by giving divergent viewpoints and rounds off on a note of caution and a piece of sage advice.

There has been a plethora of innovative products and new user groups in the credit derivatives market during the past two years. A discernible shift from single-name credit derivatives to portfolio-based products is also seen. One type of portfolio transaction that investment banks have started offering is the managed synthetic collateralized debt obligation. In this structure, the asset pool consists not of bank loans or bonds, but of credit derivatives the credit risk in the portfolio is compiled by writing single-named default protection to a series of dealers. These products securitise investment-grade corporate risk rather than high-yield debt. They offer equity investors a leveraged position in the performance of a managed, investment-grade default swap portfolio and provide debt investors with an attractive risk-adjusted return profile.

A second product type, available since late March 2002, offers investors exposure to a portfolio of liquid investment-grade credit in synthetic form, that is, by means of default swaps. JP Morgan offers this in the form of Jeci, the JP Morgan European Credit Index, and Morgan Stanley through its Synthetic Tracers. JP Morgan also offers a new index-based product called Horizon, which is the "first tool to allow investors to take a leveraged exposure to the whole credit universe". It works along similar lines to a catastrophe bond. The catastrophic event is based on movements in the index. The index (compiled by Moody's Investor's Service) comprises 2000 names, all rated between Baa3 and A1 by Moody's on January 1, 2000, can be tailored to suit investors' individual needs. If at any point, the index exceeds a specified loss trigger, the protection buyer receives a pay-out comprising the proceeds of the liquidation of the collateral transaction.

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