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Derivatives & Risk Management
Notes agrees with the protection buyer that should the spread of a particular bond exceed a
particular spread over LIBOR (strike spread), then the protection buyer will have the option, as
usual, of either a physical settlement of the reference obligation at the strike spread, or net
settlement.
The option to put the asset can be said to be the option to call a pre-determined spread. In
other words, the protection buyer intends to protect a particular spread over a base rate and
indicates a negative view on the reference obligation. On the contrary, if the protection
buyer holds a positive view on the reference obligation, he may enter into an option to call
the asset, or put the spread. Credit spread options are not related to events of default as
understandably, the movement in spreads can be related to various factors besides credit
events.
11.1.5 Repackaged Notes
Repackaged notes are also known as a repack note. It is a structured finance instrument being
a debt security in the form of an issued by a bankruptcy remote. A repack note is backed, that
is funded, by the cash flows arising from an existing security (such as an asset-backed security).
The cash flows from the existing security are channeled through a swap counterparty to
change one or more of their characteristics, such as coupon or currency. Certain other features
of the repack note may be structured differently to those of the underlying security including,
among other things, its term to maturity, interest payment frequency or credit rating.
Self Assessment
Fill in the blanks:
1. Credit derivatives is an instrument that emerged around ……………, is a part of the
market for financial derivatives.
2. Credit derivatives are derivative contracts that seek to transfer defined ……....................…..
in a credit product or bunch of credit products to the counterparty to the derivative
contract.
3. A credit default swap is essentially an …………….. .
4. Credit Linked Notes (CLNs) are a securitized form of credit derivatives which converts a
credit derivative into a …………..
5. Repackaged notes are also known as a ………….. note.
11.2 Collateralized Debt Obligations
CDOs are specialized repackaged offerings that typically involve a large portfolio of
credits. Both involve issuance of debt by a SPV based on collateral of underlying credit(s). The
essential difference between a repackaging programme and a CDO is that while a simple
repackaging usually delivers the entire risk inherent in the underlying collateral (securities
and derivatives) to the investor, a CDO involves a horizontal splitting of that risk and
categorizing investors into senior class debt, mezzanine classes and a junior debt. CDO may
be subject to local debt registration/regulatory requirements. The transactions under a CDO
are shown in Figure 11.1.
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