Demystifying Credit Risk Derivatives and Securitization:

Securitization has been a significant breakthrough in our ability to manage financial risk. In the same way that a futures contract permits exposure to price risk to be separated from ownership of a risky asset, securitization allows the separation of many types of risk exposure and other important characteristics from ownership of the securities in which they originate. Credit derivatives, in particular, can eliminate nearly all exposure to default risk for most investors in a pool of credit-risky bonds, even if the credit quality of the underlying securities is not strong. But the financial crisis of 2008 exposed several important facts: These instruments are complicated, their true risk characteristics had not been fully appreciated, and few people really understood them—apparently including some of those who were in the business of buying, selling, and creating them. This article is a basic primer on securitization of credit risk and the derivative securities that are created in the process. It provides an accessible overview that will be useful for teaching undergraduates about securitization of credit risk and as a general introduction to the subject for the non-technically-oriented reader.