Mr.

Introduction

A credit derivative is a financial product, traded Over the Counter, used to mitigate or protect against credit risk. It does so by transferring this risk from one party to another, establishing a payoff related to a change in credit, be it a default, a downgrade, or a structural change. Credit derivatives allow parties to better manage their own credit exposure and manage credit risks. Some of the more popular forms of credit derivatives are the credit default swaps, the total return swaps and the credit sensitive notes.

Credit default swaps are basically insurance policies traded by two entities whereby a payment is guaranteed against default; one party is the seller of the risk, the other one is the buyer. For example, the "SF Muni Retirement Fund" holds $100,000,000 worth of 10-year Wells Fargo Corporate Bonds. The Retirement fund enters, as investor, into a Credit default swap agreement with Goldman Sachs, the provider, agreeing to pay an undisclosed sum to GS for the reduction of the risk. If Wells Fargo does not default Goldman Sachs will receive the premium and the Retirement Fund will receive principal and interest at maturity. If Wells Fargo defaults, however, Goldman Sachs would pay the "Retirement Fund" the whole guaranteed sum.

Total Return Swaps are not pure credit derivatives as they also incorporate market risk. Total Return Swaps can be created off of almost any asset, index or security. The contract for such a swap includes two parties, the buyer, which receives interest payment plus any capital appreciation or depreciation over a specified period, while the counterparty receives a floating or fixed cash flow, unrelated to the credit worthiness of the underlying asset. Popular uses of Total Return Swaps come from Hedge Funds leveraging their limited cash flow by entering into these agreements; they receive the return of the underlying asset without having to put up any substantial sum upfront.

Credit Sensitive Notes (CSN) are debt instruments with embedded credit derivatives. With credit sensitive notes one party agrees to pay a premium or take a discount related to certain credit events. Companies could issue CSNs when there's concern about their own credit, or when it's a precursor to improving credit. In the first case a plain vanilla sale of a debt instrument would not do the job. Investors would be hesitant to buy plain vanilla bonds from a risky corporation which would force the coupon payment to be very high. In the latter case, an improving corporation that needs to raise capital fast could issue CSNs that trade at a price below market level but eventually reward the firm for any credit deterioration.

Credit Risk Management and Derivatives

Since many, if not all, derivative products are traded with embedded credit risk; to cut down on speculation with the use of credit derivatives and to reduce the volatility and uncertainty of future debt or equity issues most people take the management of credit risk as a priority. When credit risk is an issue speculators will use derivative products like CDS, or exchange traded products or techniques like puts or short selling that will raise the volatility of the underlying asset. Managing credit risk is even more important for institutions wanting to get into risk management, hedging and profit seeking derivative instruments. Since most of the aforementioned derivatives are traded OTC, they require a private placement, where the credit worthiness is the most important underlying factor. For example Bear Stearns will probably not enter into a Futures contract with a small institution like Freemont Bank, because the certainty with which the bank can make daily payments is unclear. On the other hand, this caveat would be eliminated when entering into the same agreement with a AAA rated Large Cap or Blue Chip corporation. The credit worthiness of a company could be seen as the equivalent to an individual's FICO score. By holding a poor score, the chances of accumulating any wealth will diminish as the chances of being allowed to borrow will also vanish. The same logic is applied for companies in industries where hedges will make or break company profits year in and year out.

Approaches to Managing Credit Risk

There are two things that a company needs to consider when managing its own risk:

1) If a firm owns a debt portfolio, it needs to assess its riskiness and determine if it can hedge against the exposure and how.

2) When a firm enters into financial arrangements with third-parties, it needs to evaluate the risk exposure of this third-party; in case this latter's default, the firm's own risk would increase.

First, it should be noted that a company's debt portfolio should be monitored so as to assess the value at risk or the cost of defaulting, and then decide whether this risk can be mitigated or not. Fortunately, several models already exist that price the value of a company's debt, such as CreditRisk+, CreditMetrics, and Moody's KMV model.

Second, the credit risk that a company is exposed