Page 160 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 11: Credit Derivatives

ConEd a rebate if August turned out to be cooler than expected. The measurement of this was Notes
referenced to Cooling Degree Days measured at New York City's Central Park weather station.
If total CDDs were from 0 to 10% below the expected 320, the company received no discount to
the power price, but if total CDDs were 11 to 20% below normal, ConEd would receive a $16,000
discount. Other discounted levels were worked in for even greater departures from normal.
After that humble beginning, weather derivatives slowly began trading over-the-counter in
1997. As the market for these products grew, the Chicago Mercantile Exchange introduced the
first exchange-traded weather futures contracts (and corresponding options), in 1999. The CME
currently trades weather derivative contracts for 18 U.S. cities, 9 European cities, and 2 cities in
Japan. Most of these contracts track cooling degree days or heating degree days, but recent
additions track frost days in the Netherlands and monthly/seasonal snowfall in Boston and
New York.

Task Make an analysis on credit derivatives trading in NSE for the year 2009-10.
Self Assessment

Fill in the blanks:
14. ………………..are one of the most common types of weather derivative.
15. The first weather derivative deal was in July ……………..when Aquila Energy structured
a dual-commodity hedge for Consolidated Edison Co.
11.6 Summary

 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.

 Credit derivatives can be defined as arrangements that allow one party (protection buyer
or originator) to transfer, for a premium, the defined credit risk, or all the credit risk,
computed with reference to a notional value, of a reference asset or assets, which it may or
may not own, to one or more other parties (the protection sellers).
 Credit risk may be defined overall as the risk of loss arising from nonpayment of
installments due by a debtor to a creditor under a contract.
 Formally, credit derivatives are bilateral financial contracts that isolate specific aspects of
credit risk from an underlying instrument and transfer that risk between two parties.

 A credit asset is the extension of credit in some form: normally a loan, accounts receivable,
installment credit or financial lease contract.

 Like all financial innovations, credit derivatives meet a basic need for traders in the
financial markets, which is to be capable of identifying credit risk, trading it easily via
simple market instruments, and hedging it.

 Even today, we cannot yet argue that credit risk is, on the whole, "actively" managed.
Indeed, even in the largest banks, credit risk management is often little more than a
process of setting and adhering to notional exposure limits and pursuing limited
opportunities for portfolio diversification.

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