Derivatives Pricing and Derivatives Markets

I've been working my way through Perry Mehrling's book on Fisher Black. The first part focuses on his approach to and impact on the field of finance. I just finished the part of the book that recounted the story behind the development of famous option pricing formula (the Black-Scholes formula). As a result of the pricing model, the options markets exploded in volume. This isn't surprising - once you have a better model for pricing a security, you're more wiling to trade the security. This benefits everyone, since more trading means that risk is traded (reallocated) at a greater pace.

The Wall street Journal recently had an interesting article that shows how a similar development took place in the market for credit swaps. Back in the late 90's, a banker named David Li came up with credit derivatives pricing model that incorporated the concept of "correlated default risk". This model incorporated not only the chance that an individual debt security would default, but also the risk that all (or at least, many) of the securities in a given basket would default at the same time.

This solved a big problem for issuers and purchasers of collateralized debt obligations (CDOs). In a CDO, the issuer takes a basket of debt obligations (bonds, mortgages, or whatever) and turns the basket into a new set of securities. He does this by selling various rights to receive cash flows from these pools. The cash flow rights get sliced up into "tranches", which give the holder the right to various bands of seniority of cash flow. For example, there might be a tranche that gets the right to the first million dollars of cash flows generated by the pool, or to the second, or so on. The lower seniority bands are affected much more by the risk that some of the bonds in the underlying portfolio might default. As a result, the lower-seniority tranches would have to pay a higher return.

This is where a credit default swap comes in. A default swap is a "derivative" security. In other words, its value is based on what happens to another security (in this case, a debt instrument). A default swap is essentially an insurance policy that pays off when the underlying debt instrument defaults. Because of Li's new, improved model for pricing default swaps, the market for these instruments took off. This improved market has been a boon for the residential real estate market.

Here's my reason for m,making this statement. Because of the increased ability to value default swaps, people are better able to transfer (buy and sell) risk. As a result, CDOs become more attractive as an investment (the purchaser can transfer some of the risk through a swap). So, because of the more active market for CDOs, banks and other mortgage issuers can sell off their mortgages more easily. This allows them to free up their cash and write more mortgages. As a result, the mortgage market has a greater supply of money for borrower.

This is not to say that the increased use of credit derivatives hasn't had downsides, but it is a pretty cool development.