Credit Derivatives

Credit derivatives

In finance, a credit derivative is a financial instrument or derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded."[1] Credit default products are the most commonly traded credit derivative product[2] and include unfunded products such as credit default swaps and funded products such as synthetic CDOs (see further discussion below).

Credit derivatives in their simplest form are bilateral contracts between a buyer and seller under which the seller sells protection against certain pre-agreed events occurring in relation to a third party (usually a corporate or sovereign) known as a reference entity; which affect the creditworthiness of that reference entity. The reference entity will not (except in certain very limited circumstances) be a party to the credit derivatives contract, and will usually be unaware of the contract's existence.

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 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 but 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.

Contents [hide]

1 Market Size and Participants

2 Types of Credit Derivative

2.1 Total return swap

2.2 Credit default swap

2.3 CDS options

2.4 Funded credit derivative products

2.5 Credit linked notes

2.5.1 Collateralized debt obligations (CDO)

3 Risks

4 See also

5 External links

6 Notes and references

[edit] Market Size and Participants

The ISDA[3] 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).

Although the credit derivatives market is a global one, London's market share rests at about 40 per cent., with the rest value of Europe standing at about 10 per cent.[2]

The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates. [2]

[edit] Types of Credit Derivative

There are many types of credit derivatives. Credit derivatives are fundamentally divided into two categories of product, 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. In a funded credit derivative, the credit derivative will be embedded into a bond (which will usually either be issued by an SPV or a financial institution), and bondholders will (ultimately) be responsible for the payment of any cash or physical settlement amounts.

Unfunded credit derivative products include the following products:

Total return swap (TRS)

Single name Credit default swap (CDS)

First to Default Credit Default Swap

Portfolio Credit Default Swap

Secured Loan Credit Default Swap

Credit Default Swap on Asset Backed Securities

Credit default swaption (CDS)

Recovery lock transaction

Credit Spread Option

CDS index products

Constant Maturid Credit Default Swap (CMCDS)

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)

[edit] Total return swap

Main article: Total return swap

A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets.

The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset.

The essential difference between a total return swap and a credit default swap (qv) is that the credit default swap provides protection against specific credit events. The total return swap protects against the loss of value irrespective of cause, whether default, widening of credit spreads or anything else i.e. it isolates both credit risk and market risk.

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