Page 149 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes Introduction

Credit derivatives is 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.

Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit
product or bunch of credit products to the counterparty to the derivative contract. The counterparty
to the derivative contract could either be a market participant, or could be the capital market
through the process of securitisation. The credit product might either be exposure inherent in a
credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As
the risks, and rewards commensurate with the risks, are transferred to the counterparty, the
counterparty assumes the position of a virtual or synthetic holder of the credit asset. The
counterparty to a credit derivative product that acquires exposure to the risk synthetically
acquires exposure to the entity whose risk is being traded by the credit derivative product. Thus,
the credit derivative trade allows people to trade in the generic credit risk of the entity, without
having to trade in a credit asset such as a loan or a bond.

Given the fact that the synthetic market does not have several of the limitations or constraints of
the market for cash bonds or loans, credit derivatives have become an alternative parallel
trading instrument that is linked to the value of a firm – similar to equities and bonds. Coupled
with the device of securitisation, credit derivatives have been rendered into investment products.
Thus, investors may invest in credit linked notes and gain credit exposure to an entity, or a
bunch of entities. Securitisation linked with credit derivatives has led to the commoditization of
credit risk.

11.1 Types of Credit Derivatives

The easiest and the most traditional form of a credit derivative is a guarantee. Financial guarantees
have existed for thousands of years. However, the present day concept of credit derivatives has
traveled much farther than a simple financial guarantee, and has obviously been found much
more robust in affording protection than the traditional guarantees. The following is a quick
introduction to the various types of credit derivatives.

11.1.1 Credit Default Swap

Credit default swap can literally be defined as an option to swap a credit asset for cash, should
it default. A credit default swap is essentially an option, and option bought by the protection
buyer, and written by the protection seller. The strike price of the option is the par value of the
reference asset. Unlike a capital market option, the option under a credit default swap can be
exercised only when a credit event takes place. Credit Default risk corresponds to the debtor's
incapacity or refusal to meet his contractual financial undertakings towards his creditor, whether
by payment of the interest or the principal of the loan contracted. In a credit default swap, if a
credit event takes place, the protection buyer at his option may swap the reference asset or any
other deliverable obligation of the reference obligor, either for cash equal to the par value of the
reference asset, or get compensated to the extent of the difference between the par value and
market value of the reference asset. Credit default swaps are the most important type of credit
derivative in use in the market. Moody's Investors Service gives the following definition of
default: 'Any failure or delay in paying the principal and/or the interest.' In this case,

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