Credit Derivatives

Credit derivatives are financial instruments designed to efficiently transfer
some form of risk between two or more parties. Credit derivatives can be
classified based on the form of risk that is being transferred: interest rate
risk (interest rate derivatives), credit risk (credit derivatives), currency
risk (foreign exchange derivatives), commodity price risk (commodity
derivatives), and equity prices (equity derivatives). Our focus in this
book is on credit derivatives, the newest entrant to the world of derivatives.
Credit derivatives are financial instruments that are designed to
transfer the credit exposure of an underlying asset or assets between
two parties. With credit derivatives, an asset manager can either acquire
or reduce credit risk exposure. Many asset managers have portfolios
that are highly sensitive to changes in the credit spread between a
default-free asset and credit-risky assets and credit derivatives are an
efficient way to manage this exposure. Conversely, other asset managers
may use credit derivatives to target specific credit exposures as a way to
enhance portfolio returns. In each case, the ability to transfer credit risk
and return provides a new tool for asset managers to improve performance.
Moreover, as will be explained, corporate treasurers can use
credit derivatives to transfer the risk associated with an increase in
credit spreads.
Credit derivatives include credit default swaps, asset swaps, total
return swaps, credit-linked notes, credit spread options, and credit
spread forwards. In addition, there are index-type products that are
sponsored by banks that link the payoff to the investor to a specified
credit exposure such as emerging or high yield markets. By far the most
popular credit derivatives is the credit default swap. Credit default
swaps include single-name credit default swaps and basket default
swaps. Credit default swaps have a number of applications and are used
extensively for flow trading of single reference name credit risks or, in portfolio swap form, for trading a basket of reference credits. Credit
default swaps and credit-linked notes are used in structured credit products,
in various combinations, and their flexibility has been behind the
growth and wide application of the synthetic collateralized debt obligation
and other credit hybrid products.
Credit derivatives are grouped into funded and unfunded instruments.
In a funded credit derivative, typified by a credit-linked note,
the investor in the note is the credit protection seller and is making an
upfront payment to the protection buyer when buying the note. In an
unfunded credit derivative, typified by a credit default swap, the protection
seller does not make an upfront payment to the protection buyer. In
a funded credit derivative, the protection seller is in effect making the
credit insurance payment upfront and must find the cash at the start of
the transaction; whereas in an unfunded credit derivative the protection,
payment is made on termination of the trade (if there is a credit event).
Unlike the other types of derivatives, where there are both exchangetraded
and over-the-counter (OTC) or dealer products, as of this writing
credit derivatives are only OTC products. That is, they are individually
negotiated financial contracts. As with other derivatives, they can take the
form of options, swaps, and forwards. Futures products are exchangetraded
and, as of this writing as well, there are no credit derivative futures
contracts.
Moreover, there are derivative-type payoffs that are embedded in
debt instruments. Callable bonds, convertible bonds, dual currency
bonds, and commodity-linked bonds are examples of bonds with
embedded options. A callable bond has an embedded interest rate derivative,
a convertible bond has an embedded equity derivative, a dual currency
bond has an embedded foreign exchange derivative, and a
commodity-linked bond has an embedded commodity derivative. Derivatives
have made it possible to create many more debt instruments with
complex derivative-type payoffs that may be sought by asset managers.
These debt instruments are in the form of medium-term notes and
referred to as structured products.
Credit derivatives are also used to create debt instruments with
structures whose payoffs are linked to or derived from the credit characteristics
of a reference asset (reference obligation), an issuer (reference
entity), or a basket of reference assets or entities. Credit-linked notes
(CLNs) and synthetic collateralized debt obligations (CDOs) are the
two most prominent examples. In fact, the fastest growing sector of the
market is the synthetic CDO market. Credit derivatives are the key to
the creation of synthetic CDOs.