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Hatching the Idea

Pinpointing where and when credit derivatives were born is difficult, but a 1994 party for J.P. Morgan bankers at Florida’s Boca Raton Hotel could claim that distinction. Between pranks and drinking games, the young, aggressive financiers considered new ways to profit from derivatives, which are essentially wagers on future values. Users often regard them as insurance. For example, a company may expect to receive income in foreign currency, but it pays vendors in its domestic currency. Currency markets fluctuate continuously, so how can the company make sure the foreign currency it gets will cover its obligations? The company can use a derivative to ensure that the foreign currency coming in tomorrow, next month or next year will be worth at least as much as it is today in domestic currency. The many kinds of derivatives share one trait: their value and risk depend on changes in some other asset price, like an interest rate or credit rating.

By 1994, the global interest rate and currency derivatives market already had grown to $12 trillion in volume. In its early days, during the 1980s, bankers earned rich fees on relatively simple derivatives. Yet...