Page 150 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 11: Credit Derivatives

creditors are likely to suffer a loss if they cannot recover the total amount due to them under the Notes
contract.

Did u know? What is creditworthiness risk?
Creditworthiness risk is defined as the risk that the perceived creditworthiness of the
borrower or the counterparty might deteriorate, without default being a certainty. In
practice, deteriorated creditworthiness in financial markets leads to an increase in the risk
premium, also called credit spread of the borrower. Moreover, where this borrower has a
credit rating from a rating agency, it might be downgraded. The risks of creditworthiness
deterioration and default may be correlated insofar as creditworthiness deterioration
may be the precursor of default.

11.1.2 Total Return Swaps

A Total Rate of Return Swap ("Total Return Swap" or "TR Swap") is also a bilateral financial
contract designed to transfer credit risk between parties, but a TR Swap is importantly distinct
from a Credit Swap in that it exchanges the total economic performance of a specified asset for
another cash flow. That is, payments between the parties to a TR Swap are based upon changes
in the market valuation of a specific credit instrument, irrespective of whether a Credit Event
has occurred. As the name implies, a total return swap is a swap of the total return out of a credit
asset swapped against a contracted prefixed return. The total return out of a credit asset is
reflected by the actual stream of cash flows from the reference asset as also the actual appreciation/
depreciation in its price over time, and can be affected by various factors, some of which may be
quite extraneous to the asset in question, such as interest rate movements. Nevertheless, the
protection seller here guarantees a prefixed spread to the protection buyer, who in turn, agrees
to pass on the actual collections and actual variations in prices on the credit asset to the protection
seller.
So periodically, the protection buyer swaps (the actual return on a notional value of the reference
asset), in lieu of (a certain spread on a reference rate, LIBOR + 60 bps). The swapping of principal
flows is usually avoided as the interest will anyway compensate for any deviations in the
principal flows.

11.1.3 Credit Linked Notes

Credit Linked notes (CLNs) are a securitized form of credit derivatives which converts a credit
derivative into a funded form. Here, the protection buyer issues notes or bonds which implicitly
carries a credit derivative. The buyer of the CLN sells protection and pre-funds the protection
sold by way of subscribing to the CLN. Should there be a credit event payment due from the
protection seller, the amounts due on the notes/bonds on account of credit events will be
appropriated against the same and the net, if any, will be paid to the CLN holder. The CLNs
carry a coupon which represents both the interest on the funding, as also the credit risk
premium on protection sold. Obviously the maximum amount of protection that the CLN
holder provides is the amount receivable on account of the CLN, that is, the interest and the
principal.

11.1.4 Credit Spread Options

These are basically call or put options on an asset exercisable based on a certain spread. The call
or put is an option with the holder, who is the protection buyer. Let us say a protection buyer

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