Credit derivative

1
Credit derivative
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and
then transfer the credit risk" of the underlying loan.
[1]
It is a securitized derivative whereby the credit risk is
transferred to an entity other than the lender.
[2][3]
Where credit protection is bought and sold between bilateral counterparties, this is known as an unfunded credit
derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and
payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued
by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
This synthetic securitization process has become increasingly popular over the last decade, with the simple versions
of these structures being known as synthetic CDOs; credit-linked notes; single tranche CDOs, to name a few. In
funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different
slices of credit risk according to their risk appetite.
[4]
History and participants
The market in credit derivatives started from nothing in 1993. By 1996 there was around $40 billion of outstanding
transactions, half of which involved the debts of developing countries.
[1]
Credit default products are the most commonly traded credit derivative product
[5]
and include unfunded products
such as credit default swaps and funded products such as collateralized debt obligations (see further discussion
below).
On May 15, 2007, in a speech concerning credit derivatives and liquidity risk, Geithner stated: Financial innovation
has improved the capacity to measure and manage risk.
[6]
The ISDA
[7]
reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion
with a gross market value of $948 billion (ISDA's Website
[8]
). As reported in The Times on September 15, 2008, the
"Worldwide credit derivatives market is valued at $62 trillion".
[9]
Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of
Europe having about 10%.
[5]
The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates.
[5]
Types
Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit
derivatives.
An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible
for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount)
itself without recourse to other assets.
A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial
payment that is used to settle any potential credit events. (The protection buyer, however, still may be exposed to the
credit risk of the protection seller itself. This is known as counterparty risk.)
Unfunded credit derivative products include the following products:
Credit default swap (CDS)
Total return swap
Constant maturity credit default swap (CMCDS)
First to Default Credit Default Swap
Credit derivative
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Portfolio Credit Default Swap
Secured Loan Credit Default Swap
Credit Default Swap on Asset Backed Securities
Credit default swaption
Recovery lock transaction
Credit Spread Option
CDS index products
Funded credit derivative products include the following products:
Credit linked note (CLN)
Synthetic Collateralised Debt Obligation (CDO)
Constant Proportion Debt Obligation (CPDO)
Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)
Key unfunded credit derivative products
Credit default swap
The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product
represents over thirty percent of the credit derivatives market.
[5]
The product has many variations, including where there is a basket or portfolio of reference entities, although
fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late:
credit default swaps which relate to asset-backed securities.
[10]
Key funded credit derivative products
Credit linked notes
In this example coupons from the bank's portfolio of loans are passed to the SPV which
uses the cash flow to service the credit linked notes.
A credit linked note is a note whose
cash flow depends upon an event,
which may be a default, change in
credit spread, or rating change. The
definition of the relevant credit events
must be negotiated by the parties to the
note.
A CLN in effect combines a
credit-default swap with a regular note
(with coupon, maturity, redemption).
Given its note like features, a CLN is
an on-balance-sheet asset, in contrast
to a CDS.
Typically, an investment fund manager
will purchase such a note to hedge
against possible down grades, or loan defaults.
Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. Here
we are going to provide an overview rather than a detailed account of these instruments.
The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a
less creditworthy risk.
Credit derivative
3
For example, a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that
country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its
exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from
the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank
runs into difficulty, their investments will suffer even if the country is still performing well.
The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an
enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.
There are several different types of securitized product, which have a credit dimension.
Credit-linked notes CLN: Credit-linked note is a generic name related to any bond whose value is linked to the
performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not
have to be.
Collateralized debt obligation CDO: Generic term for a bond issued against a mixed pool of assets - There also
exists CDO-squared (CDO^2) where the underlying assets are CDO tranches.
Collateralized bond obligations CBO: Bond issued against a pool of bond assets or other securities. It is referred
to in a generic sense as a CDO
Collateralized loan obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense
as a CDO
CDO refers either to the pool of assets used to support the CLNs or, confusingly, to the CLNs themselves.
Collateralized debt obligations (CDO)
Not all collateralized debt obligations (CDOs) are credit derivatives. For example a CDO made up of loans is merely
a securitizing of loans that is then tranched based on its credit rating. This particular securitization is known as a
collateralized loan obligation (CLO) and the investor receives the cash flow that accompanies the paying of the
debtor to the creditor. Essentially, a CDO is held up by a pool of assets that generate cash. A CDO only becomes a
derivative when it is used in conjunction with credit default swaps (CDS), in which case it becomes a Synthetic
CDO. The main difference between CDO's and derivatives is that a derivative is essentially a bilateral agreement in
which the payout occurs during a specific event which is tied to the underlying asset.
Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche.
These CDOs are commonly known as CDOs-squared.
Pricing
Pricing of credit derivative is not an easy process.
[3]
This is because:
The complexity in monitoring the market price of the underlying credit obligation.
Understanding the creditworthiness of a debtor is often a cumbersome task as it is not easily quantifiable.
The incidence of default is not a frequent phenomenon and makes it difficult for the investors to find the
empirical data of a solvent company with respect to default.
Even though one can take help of different ratings published by ranking agencies but often these ratings will be
different.
Credit derivative
4
Risks
Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve
issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations
for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they
exacerbate other risks in the financial system.
[3]
One challenge in regulating these and other derivatives is that the
people who know most about them also typically have a vested incentive in encouraging their growth and lack of
regulation. Incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in
keeping open doors for research.
Notes and references
[1] The Economist Passing on the risks 2 November 1996
[2] Das, Satyajit (2005). Credit Derivatives: CDOs and Structured Credit Products, 3rd Edition. Wiley. ISBN978-0-470-82159-6.
[3] Michael Simkovic, "Secret Liens and the Financial Crisis of 2008" (http:/ / ssrn. com/ abstract=1323190), American Bankruptcy Law Journal
2009
[4] Bruyere, Richard; Cont, Rama (2006). Credit Derivatives and Structured Credit: A guide for investors. Wiley. ISBN978-0470018798.
[5] "British Banker Association Credit Derivatives Report" (http:/ / www. bba. org. uk/ content/ 1/ c4/ 76/ 71/
Credit_derivative_report_2006_exec_summary. pdf) (PDF). .
[6] Remarks at the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference Credit Derivatives, Sea Island, Georgia
[7] "ISDA" (http:/ / www. isda.org). .
[8] http:/ / www. isda.org
[9] Hosking, Patrick; Costello, Miles; Leroux, Marcus (September 16, 2008). "Dow dives as Federal Reserve lines up 75bn emergency loan for
AIG" (http:/ / business. timesonline. co.uk/ tol/ business/ industry_sectors/ banking_and_finance/ article4761839. ece). The Times (London). .
Retrieved April 30, 2010.
[10] "Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer Brown" (http:/ / www.
mayerbrown.com/ london/ article.asp?id=3517& nid=1575). .
External links
A Credit Derivatives Risk Primer (http:/ / www. financialsense. com/ fsu/ editorials/ amerman/ 2008/ 0917. html)
- Simplified explanation for lay persons.
The Lehman Brothers Guide to Exotic Credit Derivatives (http:/ / www. investinginbonds. com/ assets/ files/
LehmanExoticCredDerivs. pdf)
The J.P. Morgan Guide to Credit Derivatives (http:/ / www. investinginbonds. com/ assets/ files/
Intro_to_Credit_Derivatives. pdf)
History of Credit Derivatives, Financial-edu.com (http:/ / www. financial-edu. com/ history-of-credit-derivatives.
php)
A Beginner's Guide to Credit Derivatives - Noel Vaillant, Nomura International (http:/ / www. probability. net/
credit. pdf)
Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer Brown,
Euromoney Handbooks (http:/ / www. mayerbrown. com/ london/ article. asp?id=3517& nid=1575).
Article Sources and Contributors
5
Article Sources and Contributors
Credit derivative Source: http://en.wikipedia.org/w/index.php?oldid=520653701 Contributors: Apwhite, Arcenciel, Authoress, Badaribi, Ben.douglas@btinternet.com, Beru7, Blackwong,
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