This article appears courtesy of DailyII.com
By Pierre Paulden 08/13/06
Derivatives markets were born in the 1840s, when grain farmers discovered that Chicago’s storage centers were too full to accommodate booming harvest-season supplies, yet lay empty in the spring. To guard against resulting price swings, farmers and speculators entered into contracts that locked in prices for future delivery.
Risk management has come a long way since then. Today corporations use an array of derivatives to guard against volatility in commodity prices, interest rates, currency values and even weather. But they’re having a more difficult time dealing with an increasingly potent threat: the possibility of major customers’ or suppliers’ going bankrupt.
A handful of companies, including IBM Corp. and German engineering concern Siemens, use credit default swaps to manage this risk. First developed by banks in the late 1990s to hedge their loan portfolios but now more widely used by hedge funds and other investors, default swaps are essentially insurance against corporate defaults. In a common application, an investor that owns a company’s bonds can buy a default swap from a bank, which agrees to make the investor whole for its losses if the company defaults and receives a premium in return.