Credit Derivatives
Credit derivatives are financial instruments that allow investors to manage credit risk. They are contracts whose value is derived from the performance of an underlying asset, such as a bond or loan. Common types of credit derivatives include credit default swaps, which provide insurance against the default of a borrower, and collateralized debt obligations, which repackage and redistribute credit risk.
7 Key excerpts on "Credit Derivatives"
eBook - ePub- Moorad Choudhry(Author)
- 2012(Publication Date)
- Butterworth-Heinemann(Publisher)
...Chapter 2 Credit Derivative Instruments Part I In Chapter 1 we considered the concept of credit risk and credit ratings. Credit Derivatives, introduced in 1993, isolate credit as a distinct asset class, much like how interest-rate derivatives, such as swaps and futures, isolated interest rates in the 1980s. This isolation of credit has improved the efficiency of the capital markets, because market participants can now separate the functions of credit origination and credit-risk bearing. Banks have been able to spread their credit risk exposure across the financial system, which arguably reduces systemic risk. They also improve market transparency by making it possible to price specific types of credit risk better. 1 In this chapter, we consider the various unfunded credit derivative instruments. 2 We will go on later to look at various applications of the instruments and their pricing and valuation. We begin with some observations on market participants and applications. 2.1 Credit Risk and Credit Derivatives Credit Derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. A payout under a credit derivative is triggered by a credit event associated with the credit derivative’s reference asset or reference entity. As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what constitutes a credit event. The principle behind Credit Derivatives is straightforward. Investors desire exposure to non-default-free debt because of the higher returns this offers. However, such exposure brings with it concomitant credit risk. This can be managed with Credit Derivatives. Alternatively, the credit exposure itself can be taken on synthetically if, for instance, there are compelling reasons why a cash market position cannot be established...
eBook - ePub- Frank J. Fabozzi, Frank J. Fabozzi(Authors)
- 2018(Publication Date)
- Wiley(Publisher)
...A payout under a credit derivative is triggered by a credit event. As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what constitutes a credit event. The principle behind Credit Derivatives is straightforward. Investors desire exposure to nondefault-free debt because of the higher returns that this offers. However such exposure brings with it concomitant credit risk. This can be managed with Credit Derivatives. At the same time, the exposure itself can be taken on synthetically if, for instance, there are compelling reasons why a cash market position cannot be established. The flexibility of Credit Derivatives provides users with a number of advantages and as they are over-the-counter (OTC) products, they can be designed to meet specific user requirements. We focus on Credit Derivatives as instruments that may be used to manage risk exposure inherent in a corporate or non-AAA sovereign bond portfolio. They may also be used to manage the credit risk of commercial loan books. The intense competition amongst commercial banks, combined with rapid disintermediation, has meant that banks have been forced to evaluate their lending policy, with a view to improving profitability and return on capital. The use of Credit Derivatives assists banks with restructuring their businesses, because they allow banks to repackage and parcel out credit risk, while retaining assets on balance sheet (when required) and thus maintain client relationships. As the instruments isolate certain aspects of credit risk from the underlying loan or bond and transfer them to another entity, it becomes possible to separate the ownership and management of credit risk from the other features of ownership associated with the assets in question...
eBook - ePub- Moorad Choudhry(Author)
- 2010(Publication Date)
- Wiley(Publisher)
...We then discuss the main uses of these instruments by banks and portfolio managers. We also consider the main credit events that act as triggering events under which payouts are made on credit derivative contracts. Readers should note we do not cover credit derivative pricing, which is beyond the scope of this book. This is covered in the author’s book Structured Credit Products: Credit Derivatives and Synthetic Securitisation (Choudhry, 2010). Figure 12.1 Credit Derivatives volumes, $bn notional. Source: British Bankers Association. INTRODUCTION Credit Derivatives are financial contracts designed to enable traders and investors to access specific credit-risky investments in synthetic (i.e., non-cash) form. They can also be used to hedge credit risk exposure by providing insurance against losses suffered due to credit events. Credit Derivatives allow investors to manage the credit risk exposure of their portfolios or asset holdings, essentially by providing insurance against deterioration in the credit quality of the borrowing entity. The simplest credit derivative works exactly like an insurance policy, with regular premiums paid by the protection buyer to the protection seller, and a payout in the event of a specified credit event. The principle behind Credit Derivatives is straightforward. Investors desire exposure to debt that has a risk of defaulting because of the higher returns this offers. However, such exposure brings with it concomitant credit risk. This can be managed with Credit Derivatives. At the same time, the exposure itself can be taken on synthetically if, for instance, there are compelling reasons why a cash market position cannot be established. The flexibility of Credit Derivatives provides users a number of advantages, and as they are over-the-counter products they can be designed to meet specific user requirements. What constitutes a credit event is defined specifically in the legal documents that describe the credit derivative contract...
- Dominic O'Kane(Author)
- 2011(Publication Date)
- Wiley(Publisher)
...They cover over 600 of the most important corporate and sovereign credits. They typically trade with a bid-offer spread of less than 1 basis point and frequently as low as a quarter of a basis point. 3 To understand the success of the Credit Derivatives market, we need to understand what it can do. In its early days, the Credit Derivatives market was dominated by banks who found Credit Derivatives to be a very useful way to hedge the credit risk of a bond or loan that was held on their balance sheet. Credit Derivatives could also be used by banks to manage their regulatory capital more efficiently. More recently, the Credit Derivatives market has become much more of an investor driven market, with a focus on developing products which present an attractive risk-return profile. However, to really understand the appeal of the Credit Derivatives market, it is worth listing the many uses which Credit Derivatives present: • Credit Derivatives make it easier to go short credit risk either as a way to hedge an existing credit exposure or as a way to express a negative view on the credit market. • Most Credit Derivatives are unfunded. This means that unlike a bond, a credit derivative contract requires no initial payment. As a consequence, the investor in a credit derivative does not have to fund any initial payment. This means that Credit Derivatives may present a cheaper alternative to buying cash bonds for investors who fund above Libor. It also makes it easier to leverage a credit exposure. • Credit Derivatives increase liquidity by taking illiquid assets and repackaging them into a form which better matches the risk-reward profiles of investors. • Credit Derivatives enable better diversification of credit risk as the breadth and liquidity of the Credit Derivatives market is greater than that of the corporate bond market. • Credit Derivatives add transparency to the pricing of credit risk by broadening the range of traded credits and their liquidity...
eBook - ePubDemystifying Fixed Income Analytics
A Practical Guide
- Kedar Nath Mukherjee(Author)
- 2020(Publication Date)
- Routledge India(Publisher)
...12 Credit default swaps Key learning outcomes At the end of this chapter, the readers are expected to be familiar with: Meaning and history of credit default swaps, especially in light of 2008 US subprime crisis. Different types of credit default swaps, with special reference to emerging markets. Important features of credit default swaps, in line with RBI guidelines on CDS. Current scope of CDS in India and its future challenges. Meaning and definition of Credit Derivatives Credit Derivatives are financial instruments designed to transfer the credit risk from one counterparty to another. In other words, a credit derivative is a Privately Negotiated contract the value of which is derived from the credit risk of a bond, a bank loan, or any other instrument with an exposure to credit risk. Credit Derivatives can have the form of forwards, swaps, and options, which may be embedded in financial assets like bonds or loans or other investments with a credit risk exposure. Therefore, Credit Derivatives, on the one hand, allow investors or creditors to eliminate or reduce credit risk involved in their investment, and allow the counterparty to make some profit and leverage their position by assuming the credit risk in their own books of accounts. On the other hand, Credit Derivatives can be defined as arrangements that allow one counterparty (Protection Buyer) to transfer, in exchange of a certain price called Premium, the defined credit risk (full or in part), computed with reference to a notional value, of a reference asset(s), with or without its actual ownership, to another counterparty or counterparties (Protection Seller). There are different basic and complex or synthetic derivatives products or instruments used to mitigate the credit risk that a person or entity carries in their books of accounts...
- Antulio N. Bomfim(Author)
- 2015(Publication Date)
- Academic Press(Publisher)
...to the investor. In the end, they would each be exposed to the types of risks that they feel comfortable with, without having to take on, in the process, unwanted risk exposures. As simple as the above example is, it provides a powerful rationale for the existence of the expanding market for Credit Derivatives. Indeed, Credit Derivatives are financial contracts that allow the transfer of credit risk from one market participant to another, potentially facilitating greater efficiency in the pricing and distribution of credit risk among financial market participants. Let us carry on with the above example. Suppose the bank enters into a contract with the investment firm whereby it will make periodic payments to the firm in exchange for a lump sum payment in the event of default by XYZ Corp. during the term of the contract. As a result of entering into such a contract, the bank has effectively transferred at least a portion of the risk associated with default by XYZ Corp. to the investment firm. (The bank will be paid a lump sum if XYZ defaults.) In return, the investment company gets the desired exposure to XYZ credit risk, and the stream of payments that it will receive from the bank represents compensation for bearing such a risk. The basic features of the financial contract just described are the main characteristics of one of the most prevalent types of Credit Derivatives, the credit default swap. In the parlance of the Credit Derivatives market, the bank in the above example is typically referred to as the buyer of protection, the investment firm is known as the protection seller, and XYZ Corp. is called the reference entity. 1 1.2 Potential “Gains from Trade” The previous section illustrated one potential gain from trade associated with Credit Derivatives. In particular, Credit Derivatives are an important financial engineering tool that facilitates the unbundling of the various types of risk embedded, say, in a fixed-rate corporate bond...
eBook - ePub- Frank J. Fabozzi, Frank J. Fabozzi(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
...Credit Derivatives and Hedging Credit Risk DONALD R. VAN DEVENTER, PhD Chairman and Chief Executive Officer, Kamakura Corporation Abstract: The credit crisis of 2007–2009 in the United States and Europe and the collapse of the Japanese bubble in the 1990–2002 period show that, without hedging credit risk, the largest financial institutions in the world are very likely to fail. Many trillions of dollars of taxpayer bailouts have put the credit quality of the United States and Japan at risk. The solution to this financial institutions’ risk management problem and the related sovereign risk problem is hedging with respect to macro factor movements. Hedging interest rate movements has a 40-year history, but now the focus has turned to a longer list of macro factors like home prices, commercial real estate prices, oil prices, commodity prices, foreign exchange rates, and stock indices. This hedging capability is now widely available in best practice enterprise risk management software. Stress testing with respect to macro factors is now a mandatory requirement of the European Central Bank and U.S. bank regulators. In this entry, we examine practical tools for hedging credit risk at both the transaction level and the portfolio level, focusing on the interaction between the credit modeling technologies and traded instruments that would allow one to mitigate credit risk. We start with a discussion linking credit modeling and credit portfolio management in a practical way. We then turn to the credit default swap market as a potential hedging tool...
