Credit Derivative

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Definition: Credit Derivative




What is the dictionary definition of Credit Derivative?

Dictionary Definition


A credit derivative is an OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks.


Full Definition of Credit Derivative


A Credit Derivative is a contract to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. This is usually achieved by transferring risk on a credit reference asset. Early forms of credit derivative were financial guarantees. Some common forms of credit derivatives are total return swap, credit default swap and credit-linked note.

Credit derivatives take many forms.

Three basic structures include:

  • Credit default swap: Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs. Credit events are typically defined to include a material default, bankruptcy or debt restructuring for a specified reference asset. If such a credit event occurs, the party makes a payment to the first party, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset’s market value following the credit event.
  • Total return swap: Two parties enter an agreement whereby they swap periodic payment over the specified life of the agreement. One party makes payments based upon the total return—coupons plus capital gains or losses—of a specified reference asset. The other makes fixed or floating payments as with a vanilla interest rate swap. Both parties’ payments are based upon the same notional amount. The reference asset can be almost any asset, index or basket of assets.
  • Credit-linked note: A debt instrument is bundled with an embedded credit derivative. In exchange for a higher yield on the note, investors accept exposure to a specified credit event. For example, a note might provide for principal repayment to be reduced below par in the event that a reference asset defaults prior to the maturity of the note.

The fundamental difference between a credit default swap and a total return swap is the fact that the credit default swap provides protection against specific credit events. The total return swap provides protection against loss of value irrespective of cause – a default, market sentiment causing credit spreads to widen, etc.

Most credit derivatives entail two sources of credit exposure: one from the reference asset and the other from possible default by the counterparty to the transaction.

Key Concepts Of The Credit Derivatives Market

The idea of credit derivatives is to avoid direct ownership of the securities referenced in the transaction. This is achieved, as elsewhere in financial markets, by the use of a reference rate and other reference concepts such as;

  • Reference entity (aka reference credit): A specified legal entity, which may be a sovereign, financial institution, corporation, or one of a number of specified entities.
  • Reference Asset: A generic term for any holding, obligation, debt or another form of credit instrument that is “referenced” in the transaction.
  • Reference Security: Usually, a public security issued by the reference entity, but also a reference asset or reference obligation such as a loan or other financial asset.
  • Credit Event: An event defined within the credit derivatives contract, that happens in respect of the reference entity. It is usually defined in the Master Agreement of a credit derivatives contract.

The three credit events under ISDA (2003) definitions are Bankruptcy, Failure to Pay, Restructuring.

Global Market For Credit Derivatives

The global market for credit derivatives is growing exponentially and now exceeds $4 trillion. As the market expands, an ever-growing range of instruments has become available, ranging from “plain vanilla” credit default swap (CDS) to complex basket trades such as synthetic collateral debt obligations (CDOs). The size of the market has grown incredibly in the last few years. The fastest-growing segment of the credit derivatives arena is the credit default swap (CDS) market.

Credit Risk

Credit risk is the risk that a borrowing entity will default on a loan, either through inability to maintain the interest servicing or because of bankruptcy or insolvency leading to inability to repay the principal itself. When technical or actual default occurs, bondholders suffer a loss as the value of their asset declines, and the potential greatest loss is that of the entire asset. The extent of credit risk fluctuates as the fortunes of borrowers changes in line with their own economic circumstances and the macroeconomic business cycle.

The magnitude of risk is described by a firm’s credit rating. Rating agencies undertake a formal analysis of the borrower, after which a rating is announced; the issues considered in the analysis include:

  • the financial position of the firm itself, for example, its balance sheet position and anticipated cash flows and revenues;
  • other firm-specific issues such as the quality of the management and succession planning;
  • an assessment of the firm’s ability to meet scheduled interest and principal payments, both in its domestic and foreign currencies;
  • the outlook for the industry as a whole, and competition within it;
  • general assessments for the domestic economy.

Another measure of credit risk is the credit risk premium, which is the difference between yields on the same-currency government benchmark bonds and corporate bonds. This premium is the compensation required by investors for holding bonds that are not default-free. The credit premium required will fluctuate as individual firms and sectors are perceived to offer improved or worsening credit risk, and as the general health of the economy improves or worsens.

Credit Risk And Credit Derivatives

Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. A payout under a credit derivative is triggered by a credit event. As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what constitutes a credit event.

The principle behind credit derivatives is straightforward. Investors desire exposure to non-default free sovereign debt because of the higher returns this offers. However such exposure brings with it concomitant credit risk. This can be managed with credit derivatives. At the same time, the exposure itself can be taken on synthetically if, for instance, there are compelling reasons why a cash market position cannot be established. The flexibility of credit derivatives provides users with a number of advantages and as they are over-the-counter (OTC) products they can be designed to meet specific user requirements.

Credit derivatives, an instrument that emerged around 1993-94, is a part of the market for financial derivatives. Since credit derivatives are presently not traded on any of the organised exchanges, they are a part of the over-the-counter (OTC) derivatives market. Though still a relatively small part of the huge market for OTC derivatives, credit derivatives are growing faster than any other OTC derivative, the reasons for which are not difficult to understand.

The development of credit derivatives is a logical extension of the ever-growing array of derivatives trading in the market. The concept of a derivative is to create a contract that transfers some risk or some volatility. This risk or volatility may relate to the price or performance of a reference asset, event, a market price or any other economic or natural phenomenon. Such trade in risk does not mean a trade in the reference asset. The reference may remain with someone who is a complete stranger to the derivative contract. However, the derivative trade closely mimics and risks and returns of holding the underlying asset, or at least a segment thereof. Thus, derivatives bring about a completely independent trade in the risks/returns of an asset. For example, a trade in options or futures in equities, may run completely independent of trades in equity shares.

Credit derivatives apply the same notion to a credit asset. Credit asset is the asset that a provider of credit creates, such as a loan given by a bank, or a bond held by a capital market participant. A credit derivative enables the stripping of the loan or the bond, from the risk of default (or more risks, depending on the nature of the derivative), such that the loan or the bond can continue to be held by the originator or holder thereof, but the risk gets transferred to the counterparty. The counterparty buys the risk obviously for a premium, and the premium represents the rewards of the counterparty.

Thus, credit derivatives essentially use the derivatives format to acquire or shift risks and rewards in credit assets, viz., loans or bonds, to other financial market participants. Like capital market derivatives, credit derivatives make it possible to hold a credit asset, but sack off the risks in holding it and replace the same by either a pure counterparty risk or risk is a safer asset. Reciprocally, credit derivatives make it possible to not hold a credit asset and yet synthetically create the position of risk and reward in a credit asset or portfolio of assets.

Securitisation

Much of the significance that credit derivatives enjoy today is because of the marketability imparted by securitisation. Credit derivatives would have mostly been a closely-held esoteric market, but for the introduction of securitisation device to commoditise a credit derivative and bring it to the capital market.

Securitised credit derivatives, or synthetic securitisation, is a device of embedding a credit derivative feature into a capital market security so as to transfer the credit risk into the capital markets. In the case of synthetic securitisations, the protection against the risk is ultimately provided by the capital markets.

The synthesis of credit derivatives with securitisation methodology has complemented each other. Credit derivatives have acquired a new meaning when they were turned into marketable securities using securitisation techniques; securitisation. on the other hand. got a new impetus by opening up possibilities of keeping a whole portfolio of credit assets on books and yet transfer the credit risks of the portfolio. Lot of erstwhile securitisers over Europe and Asia are preferring synthetic securitisations to cash transfers.

Credit derivatives have many implications for bank portfolio managers, including the ability to hedge and diversify their portfolio quickly at market prices. Credit derivatives are also useful for the information they provide about the price of pure credit risk, which bank managers can incorporate into their internal pricing decisions. And finally, credit derivatives have become a key feature of securitizations.

Credit Default Swap

The Credit default swap or CDS has become the main engine of the credit derivatives market, offering liquid price discovery and trading on which the rest of the market is based. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event happening in the reference entity. The contingent payment usually replicates the loss incurred by creditors of the reference entity in the event of its default. It covers only the credit risk embedded in the asset, risks arising from other factors such as interest rate movements remaining with the buyer.

Total Return Swap

A total return swap (a.k.a. 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 the 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.

Difference

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

Pricing

The calculation of an approximate price for a credit default swap requires the use of arbitrage arguments. Compare (a) the return achieved by one who pays £100 for a risky bond B maturing at time T and (b) the return achieved by one who invests £100 at the risk-free rate, until time T, and simultaneously sells protection via a CDS on bond B.
Clearly both positions have a similar risk, which is of bond B going into default. In case (a) the investor gets only the recovery rate attached to B (the amount given a creditor of this type can recover on liquidation), in case (b) the seller of the CDS must purchase bond B for its face value, £100, which entails liquidating the risk-free investment and selling B at its recovery value. Arbitrage arguments suggest that similar risks should be compensated by a similar excess return. Thus the premium paid to the seller of the CDS should be approximately equal to the difference between the coupon of B, and the risk-free rate.

To facilitate pricing, the premium on a CDS is paid at a similar frequency to that in the swap and bond markets (typically quarterly).

The pricing method is approximate in that it ignores the credit risk of the CDS seller, who may be unable to buy the bond in the event of default (suppose in an extreme case that the seller is also the issuer of the bond which is protected).

Credit Linked Note

A note whose cash flow depends upon a credit event, which can be a default, 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 regular-note 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 downgrades or loan defaults.

Levels And Flows

The BIS reported in December 2004 that notional principal of outstanding OTC credit derivatives contracts which grew more than sixfold during three years between end-June 2001 and end-June 2004


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Definition Sources


Definitions for Credit Derivative are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 17th April, 2020 | 29 Views.