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Credit DerivativesCHAPTER 7

Credit derivatives

Collaterized debt obligation

Credit default swap

Credit spread options

Credit linked notes

Risks in credit derivatives

Credit Derivatives•A credit derivative is a financial instrument whose value is determined by

the default risk of the principal asset.

•Financial assets like forward, options and swaps form a part of Credit

derivatives

•Borrowers can default and the lender will need protection against such

default and in reality, a credit derivative is a way to insure such losses

Credit Derivatives•Credit default swaps (CDS), total return swap, credit default swap options, collateralized debt obligations (CDO) and credit spread forwards are some examples of credit derivatives

•The credit quality of the borrower as well as the third party plays an important role in determining the credit derivative’s value

Credit Derivatives•Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives.

•There is a contract between both the parties stating the responsibility of each party with regard to its payment without resorting to any asset class

Credit Derivatives•The level of risk differs in different cases depending on the third party and a fee is decided based on the appropriate risk level by both the parties.

•Financial assets like forward, options and swaps form a part of Credit derivatives

•The price for these instruments changes with change in the credit risk of agents such as investors and government

Credit derivatives

Collaterized debt obligation

Credit default swap

Credit spread options

Credit linked notes

Risks in credit derivatives

Collaterized Debt obligation•CDOs or Collateralized Debt Obligation are financial instruments that banks and other financial institutions use to repackage individual loans into a product sold to investors on the secondary market.

Collaterized Debt obligation•A collateralized debt obligation (CDO) is an example of structured asset-backed security (ABS).

•Different assets which generate cash can be pooled together and then repackaged into various discrete tranches in order to sell it to the investors

•The junior tranches offer higher coupon rates because of the high risk involved.

Collaterized Debt obligation•With the help of CDOs banks can give more loans because of greater liquidity. This happens because of more cash at their disposal

Collaterized Debt obligation•One of the major advantages of CDO was its ability to provide liquidity to the economy and therefore they were a welcomed innovation in finance

•With the help of CDOs, banks and corporations had more money at their disposal which helped them to invest and give loan

Collaterized Debt obligation•CDOs are created with the help of a computer model

•An asset bubble was created because of the extra liquidity in the market

•Banks went on selling CDOs without thinking too much about the payments because they had sold these loans to investors and they were the one who would be affected if people default

Credit derivatives

Collaterized debt obligation

Credit default swap

Credit spread options

Credit linked notes

Risks in credit derivatives

Credit Default SwapsA credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds

Credit Default Swaps•Swap sellers use diversification to protect themselves

•They provide as sellers in different industries so that even if one of them defaults entirely they will be getting annual payments from the other industries to make up for the losses

Credit Default Swaps•Until 2009 swaps were not regulated. It led to a situation where there was no one to see if the person selling the CDS even had enough money to pay the CDS buyer in case the bond had defaulted

Credit derivatives

Collaterized debt obligation

Credit default swap

Credit spread options

Credit linked notes

Risks in credit derivatives

Credit Spread Options•Yield difference between the U.S. Treasury bond and a debt security with the same maturity but with not so good quality is known as credit spread

Credit spread options•. A strategy of buying low premium option and selling high premium option also comes under credit spread

•. Credit spreads are measured in basis points

Credit derivatives

Collaterized debt obligation

Credit default swap

Credit spread options

Credit linked notes

Risks in credit derivatives

Credit linked notes•A credit linked note (CLN) is a type of funded credit derivative

•. It is prepared as a security with an embedded credit default swap which helps the issuer in transferring credit risks to the investors

Credit linked notes•The difference here is that the issuer is not under any obligation to repay the debt in case of a specified event.

Credit linked notes•The motive of the deal is to pass the danger of specific default onto investors eager tolerate that danger in exchange for the higher earnings it makes obtainable.

•The CLNs themselves are typically backed by very highly rated collateral, such as U.S. Treasury securities.

Credit derivatives

Collaterized debt obligation

Credit default swap

Credit spread options

Credit linked notes

Risks in credit derivatives

Risks in credit derivatives•Credit derivatives are popular in the financial world where there is a lot of risk and where the yield is low

•Commercial banks, hedgers as well as insurance company show a lot of interest on credit derivates

Risks in credit derivatives•While on one hand they provide high yield returns to a seller, on the other hand they help the buyer to manage portfolio risk

•Some insurance companies and commercial banks have the tendency to be too aggressive which leads to distortion of the prices

Risks in credit derivatives•Many people entire the market because of the attractive high yield and they feel that they can absorb the risk but only a few of them are able to survive in the market and understand the risk of the credit derivates.

Risks in credit derivatives•The increasing use of credit derivatives have increased the risk because many banks and insurance companies are taking on risks which they are not able to understand properly

•In contrast to other loans, the credit derivatives hold a vast number of debts from various organizations

Risks in credit derivatives•In order to get more returns, some companies have focused the most on the most risky segment and thereby creating the probability of huge losses at the same time.

Risks in credit derivativesInvestors need to be able to understand the likelihood of default by individual companies so that they know the total loss amount which they can incur.

The situation is unsettling because insurance companies do not face the rigorous capital requirements.

“Too many people spend money they

haven't earned, to buy things they

don't want, to impress people that

they don't like.”

- Will Rogers

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