Information about Credit Derivative
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.
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.<ref name="BBACDR" />
The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates. <ref name="BBACDR" />
Unfunded credit derivative products include the following products:
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.
A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfil certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.
The relevant credit events specfied in a transaction will usually be selected from amongst the following: the bankruptcy of the reference entity; its failure to pay in relation to a covered obligation; it defaulting on an obligation or that obligation being accelerated; it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.
If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle.
This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness).
Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss. The protection seller has no recourse to and no right to sue the reference entity for recovery.
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 or Credit Default Swaps on Asset-Backed Securities"[4].
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 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 a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO.
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.
For example, if you borrow money and have to pay interest once a month, you have issued a fixed-income security.
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)
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.
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.<ref name="BBACDR" />
The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates. <ref name="BBACDR" />
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)
- Credit linked note (CLN)
- Synthetic Collateralised Debt Obligation (CDO)
- Constant Proportion Debt Obligation (CPDO)
- Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)
Total return swap
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.
Credit default swap
A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfil certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.
The relevant credit events specfied in a transaction will usually be selected from amongst the following: the bankruptcy of the reference entity; its failure to pay in relation to a covered obligation; it defaulting on an obligation or that obligation being accelerated; it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.
If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle.
This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness).
Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss. The protection seller has no recourse to and no right to sue the reference entity for recovery.
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 or Credit Default Swaps on Asset-Backed Securities"[4].
CDS options
A CDS option represents the right but not the obligation to buy or sell protection on an underlying reference credit at a specified strike spread at a specified date in the future. There are two types of options that can be bought or sold:- the right to buy credit protection (payer option)
- the right to sell protection (receiver option)
Funded credit derivative products
Credit linked notes
A credit linked note is 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 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.
- 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
Collateralized debt obligations (CDO)
In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO.
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.
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. (The incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.)See also
External links
- The Lehman Brothers Guide to Exotic Credit Derivatives
- The J.P. Morgan Guide to Credit Derivatives
- History of Credit Derivatives, Financial-edu.com
- A Beginner's Guide to Credit Derivatives - Noel Vaillant, Nomura International
- Credit Derivative: a riskglossary
- Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer Brown, Euromoney Handbooks.
Notes and references
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In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices
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The bond market, also known as the debt, credit, or fixed income market, is a financial market where participants buy and sell debt securities usually in the form of bonds. The size of the international bond market is an estimated $45 trillion of which the size of outstanding U.S.
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Fixed income refers to any type of investment that yields a regular (or fixed) return.For example, if you borrow money and have to pay interest once a month, you have issued a fixed-income security.
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A corporate bond is a bond issued by a corporation. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. (The term "commercial paper" is sometimes used for instruments with a shorter maturity.
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A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.
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In finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment grade at the time of purchase.
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A stock market is a market for the trading of company stock, and derivatives of same; both of these are securities listed on a stock exchange as well as those only traded privately.
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Preferred stock, also called preferred shares or preference shares, is typically a higher ranking stock than common stock, and its terms are negotiated between the corporation and the investor.
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A stock exchange, share market or bourse is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities.
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The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators,
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The Retail forex (Retail Currency Trading or Retail Forex or Retail FX) market is a subset of the larger Foreign exchange market.
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- Capital price:
- *Price moves in line with share price (fixed conversion terms e.g.
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A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated.
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swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap.
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Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.
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Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is the opposite of exchange trading which occurs on futures exchanges or stock exchanges.
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Property law
Part of the common law series
Acquisition of property
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Lost, mislaid, and abandoned property
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Lost, mislaid, and abandoned property
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The Spot Market or Cash Market is a commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective.
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Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects.
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In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices
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