On the credit risk of OTC derivative users

A unique data set is constructed using publicly available information from financial reports filed with the S.E.C. The data set is used to examine trends in the credit quality of firms reporting the use of over-the-counter (OTC) derivatives. Contrary to popular belief, the OTC derivative marketplace is not found to be closed to poor (indeed speculative) credit quality firms. Further, the data reveal that the newer participants in the OTC derivative marketplace increasingly tend to have poorer credit qualities than the older participants. The industry's stated reluctance to do business with poorer credit risks combined with diagnostic tests suggests a reliance on collateralization. The credit quality comparisons are then used to assess Federal Reserve Board policy on credit risk weights for OTC derivative positions of banks.