The Art of Credit Derivatives: Demystifying the Black Swan

8

Standardized Credit Indices

Mediocrity does not see higher than itself. But talent instantly recognizes the genius.

Sir Arthur Conan Doyle

8.1 INTRODUCTION

In order to help us understand the rationale behind the standardized credit indices, we will begin by discussing the well-known equity stock market indices. There are several reasons why the equity indices are there. They help investors track the performance of sectors, ultimately serving as a mechanism for pricing discovery of the sectors they represent. The performance of a portfolio of equity instruments is usually compared with a passive index representing the sector in which the manager is supposed to invest.

Technically speaking, the idea of an index is backed by Markowitz; instead of taking idiosyncratic risk on one company, an investor is better off taking a sector diversified risk by buying the sector index to which the company belongs. Back in the 1970s, innovation brought the options market as a tool for portfolio managers and investors alike to hedge their risks. The simple existence of an equity index with an exchange traded liquid option market increases liquidity as investors have access to more information on the underlying market. Exchange traded funds (ETF) are further examples of the impact of innovation underlying the financial activity. They are the ultimate commoditization of the idea of indices as they make indices easily accessible to individual investors.

Standardized credit indices are for the ...