Introduction To Credit Derivatives
Stephen P. D’Arcy and Xinyan Zhao
What are Credit Derivatives?
“Credit derivatives are derivative instruments
that seek to trade in credit risks. ”
http://www.credit-eriv.com/meaning.htm
What are Derivatives?
A financial contract that has its price derived from, and depending upon, the price of an underlying asset.
The underlying assets might be traded.
Types of Derivatives include, Swaps, Options and Futures for example.
What is Credit Risk?
The risk that a counterparty to a financial transaction will fail to fulfill their obligation.
Growth in Credit Derivatives
Source:BBA Credit Derivatives Report 2006
Types of credit derivatives
– Credit default swap
– Credit spread option
– Credit linked note
What is Credit default swap?
Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."
Example
Suppose Bank A buys a bond which issued by a Steel Company.
To hedge the default of Steel Company: Bank A buys a credit default swap from
Insurance Company C.
Bank A pays a fixed periodic payments to C, in exchange for default protection.
Exhibit Credit Default Swap
Bank A BuyerInsurance Company C
Seller
Steel company
Reference Asset
Contingent Payment On
Credit Event
Premium Fee
Credit Risk
What is credit spread option?
A credit spread option grants the buyer the right, but
not the obligation, to purchase a bond during a
specified future “exercise” period at the
contemporaneous market price and to receive an
amount equal to the price implied by a “strike spread” stated in the contract.
Credit Spread
The different between the yield on the borrower’s
debt (loan or bond) and the yield on the referenced
benchmark such as U. S. Treasury debt of the same
maturity.
Example
An investor may purchase from an insurer an option
to sell a bond at a particular spread above LIBOR
Credit spread.
If the spread is higher on the exercise date, then the option will be exercised. Otherwise it will lapse.
ExhibitProfit
Spot priceStrike price
Credit-linked notes
A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the
note issuer to the investor.
The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.
If a credit event is declared, the issuer sells the collateral and keeps the difference between the face value and market value of the reference entity’s debt.
Example
Refer to the Steel company case again.
Bank A would extend a $1 million loan to the Steel Company.
At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.
If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.
Exhibit
Bank A Institutional investors
Steel Company
$1 Million
fixed or floating coupon,if defaults or declares bankruptcy the investors receive an amount equal to the recovery rate
$1million
500b p
Steel
Company
Credit Derivatives Market ParticipantsSource:British Bankers Association (BBA) 2003/2004 Credit Derivatives Report
Buyers
Banks Secur i t i es Fi rmsHedge Funds CorporatesI nsures/ Rei nsurers Mutual FundsPensi on Funds Government
For the protection buyer(the risk seller)
– to transfer credit risk on an entity without transferring the underlying instrument– regulatory benefit– reduction of specific concentrations portfolio management
– to go short credit risk
Credit Derivatives Market ParticipantsSource:British Bankers Association (BBA)
Sel l ers
Secur i t i es Fi rms BanksGovernment Pensi on FundsMutual Funds I nsures/ Rei nsurersCorporates Hedge Funds
For the protection seller(the risk buyer)
– diversification
– leveraged exposure to a particular credit
– access to an asset which may not
otherwise be available to the risk buyer
sourcing ability
– increase yield
Questions
1. Does your bank use credit derivatives? If yes,
a. What type?
b. How long?
c. What is the primary purpose?
2. Do you think that most bankers in China understand credit derivatives? If not,
a. What could help them understand credit derivatives better?
b. What would be the most effective way to help?
3. Do you think banks in China should use credit derivatives to manage credit risk?
a. What problems need to be solved to improve risk management?
b. Do regulations need to be changed?
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