We propose implied spreads (IS) and normalized implied spreads (NIS) as simple measures to characterize option prices. IS is the credit spread of an option’s implied bond, the portfolio long a risk-free bond and short a put option. NIS normalizes IS by the risk-neutral default probability and reflects tail risk. IS and NIS are countercyclical and predict implied bond returns, while neither, like implied volatility, predicts put returns. These opposite predictability results are consistent with a stochastic volatility, stochastic jump intensity model, as put premia increase in volatility but decrease in jump intensity, while implied bond premia increase in both.

No-arbitrage relationships characterize relative prices of credit default swaps (“CDSs”) vis-à-vis bonds and equities issued by the same reference entities. We review the empirical academic literature on which of the three markets is the Primary Price Discovery Market (“PPDM”) and find that CDS spreads lead corresponding cash bond prices in price discovery. The PPDM is more empirically ambiguous when comparing CDSs and equities. We also review the empirical evidence on the impact of the introduction of CDSs on bond and equity markets’ liquidity, which broadly demonstrates that the introduction of single-name CDS trading initially has adverse impacts on the liquidity of related debt and equity markets, but that those effects are transitory and may be later reversed as the related markets reach a joint equilibrium.

Shadow banking is the process by which banks raise funds from and transfer risks to entities outside the traditional commercial banking system. Many observers blamed the sudden expansion in 2007 of U.S. sub‐prime mortgage market disruptions into a global financial crisis on a “liquidity run” that originated in the shadow banking system and spread to commercial banks. In response, national and international regulators have called for tighter and new regulations on shadow banking products and participants. Preferring the term “market‐based finance” to the term “shadow banking,” the authors explore the primary financial instruments and participants that comprise the shadow banking system. The authors review the 2007–2009 period and explain how runs on shadow banks resulted in a liquidity crisis that spilled over to commercial banks, but also emphasize that the economic purpose of shadow banking is to enable commercial banks to raise funds from and transfer risks to non‐bank institutions. In that sense, the shadow banking system is a shock absorber for risks that arise within the commercial banking system and are transferred to a more diverse pool of non‐bank capital instead of remaining concentrated among commercial banks. The article also reviews post‐crisis regulatory initiatives aimed at shadow banking and concludes that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of market‐based capital available for non‐bank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.

Credit default swaps (“CDSs”) based on asset-backed securities (“ABSs”) (including residential mortgage-backed securities (“RMBSs”), home equity loan-based ABSs, and tranches of collateralized debt obligations (“CDOs”)) are not amenable to the same ISDA credit definitions applied to single-name CDSs based on specific reference entities. To address the specialized nature of CDSs backed by ABSs, ISDA published in 2005 and 2006 “pay-as-you-go” documentation that was better suited to the cash flows of ABSs and complications raised by the issuance of ABSs by special purpose entities (“SPEs”). Although such asset-backed CDSs (“ABCDSs”) have virtually disappeared since the outbreak of the credit crisis, the fundamental idea behind pay-as-you-go ABCDSs is sound, and such products could well re-emerge again (albeit not necessarily based on US subprime mortgage-based ABSs).

We review the empirical academic literature on the informational content of credit default swap ("CDS") spreads. Most of this literature posits and empirically documents that CDS spreads generally: (i) contain valuable information about the probability and severity of adverse credit events that the underlying reference entities may experience during the life of the CDS; (ii) reflect a risk premium that protection sellers demand to compensate them for reference entity-specific and systematic risks (both credit-related and non-credit-related); and (iii) are anticipatory and contain information regarding future announcements about the credit risk and financial condition of the underlying reference entity.

We discuss the underlying market for broadly syndicated leveraged loans that characterize the deliverable loans on which most loan-only CDSs (“LCDSs”) are based. We then review the significant distinctions between single-name CDSs (typically based on bonds issued by reference entities) and LCDSs with loan-specific deliverable obligations. Such distinctions include reference entity credit events that trigger LCDSs, the timing of coupon payments on LCDSs, the specific obligations underlying LCDSs that are deliverable into LCDS-specific auctions or physical settlements, and the embedded cancellation options in LCDSs corresponding to prepayments on underlying broadly syndicated term loans.

Credit default swaps (“CDSs”) can benefit market participants in various ways. CDSs can benefit lenders to CDS reference entities in the credit risk management process. By supplementing loan sales and securitizations with another credit risk management tool, CDSs give lenders flexibility in choosing a preferred credit risk transfer solution, which can free up capital and facilitate additional lending to reference entity borrowers. CDSs can also benefit investors by enabling them to make synthetic investments in the unfunded reference entity’s bonds. Finally, CDS prices can provide useful information to CDS users and other market participants about the expected default risks, recovery rates, potential interconnectedness, and other aspects of underlying reference names. We discuss here these potential benefits of CDSs.

Derivatives that are negotiated over-the-counter (OTC), but cleared and settled through central counterparties have grown in popularity since their first appearance in the 1990s. Such “OTC-cleared” derivatives have both benefits and costs that can vary significantly across market participants and product types. This article explores the evolution of OTC-cleared derivatives and those benefits and costs. Particular attention is paid to the regulatory framework for OTC derivatives, which was recently substantially overhauled with the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the new Act, the clearing and settlement of many OTC derivatives through a central counterparty (CCP) is now mandatory. The challenges and risks likely to arise from these new regulations are also explored here for clearinghouses, swap dealers, and major users of OTC derivatives.

From 2011 through 2014, new issuance of U.S. structured products backed by subprime auto loans and leveraged corporate loans grew by 55% and 716%, respectively. We analyze the recent activity in these markets, as well as the activity and risks in the loan markets underlying auto asset-backed securities (ABS) and collateralized loan obligations (CLOs). Despite the empirical evidence that we present of higher risks in auto and leveraged loan collateral, our analysis does not indicate a commensurate increase in risks to investors in the structured products based on those loans. For a comparison, we review market activity and risk indicia in U.S. insurance-linked securities, which, unlike auto ABS and CLOs, serve a pure risk transfer purpose and do not result in any significant extension of credit by investors to sponsors. We also consider the likely impacts of the Volcker rule and Credit Risk Retention rule on U.S. structured product markets, and we conclude that the regulations are likely to stifle market activity and discourage legitimate risk transfer.