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(Redirected from Credit derivatives) In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.[1] This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.[2] Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.[2] The parties will select which credit events apply to a transaction and these usually consist of one or more of the following: bankruptcy (the risk that the reference entity will become bankrupt) failure to pay (the risk that the reference entity will default on one of its obligations such as a bond or loan) obligation default (the risk that the reference entity will default on any of its obligations) obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be declared immediately due and payable following a default) repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the reference entity's obligations) restructuring (the risk that obligations of the reference entity will be restructured)... 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.
Contents
1 Market size and participants 2 Types 2.1 Key unfunded credit derivative products 2.1.1 Credit default swap 2.1.2 Total return swap 2.2 Key funded credit derivative products 2.2.1 Credit linked notes 2.2.2 Collateralized debt obligations (CDO) 3 Pricing 4 Risks 5 See also 6 Notes and references 7 External links
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. However, the protection buyer is exposed to the credit risk of the protection seller, in which case the protection seller fails to pay the protection buyer under the event of the protection seller's default. It is also 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
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)
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. 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. CLN 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.
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.
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) Main article: collateralized debt obligation Contrary to popular belief, not all collateralized debt obligations (CDOs) are credit derivatives. For example a CDO made up of leveraged 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. 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.
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. 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.)
See also
Credit default swap Credit linked note
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) . Retrieved from "http://en.wikipedia.org/wiki/Credit_derivative" Categories: Derivatives (finance) This page was last modified on 17 July 2011 at 00:16. Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. See Terms of use for details. Wikipedia is a registered trademark of the Wikimedia Foundation, Inc., a non-profit organization.