Credit Derivatives explained in detail

In our earlier article of OTC derivatives, we have given a brief on OTC derivatives and its types. Taking the article forward, we are explaining one of the essential types of OTC derivatives namely Credit Derivatives.

Derivative is financial contract that has its price derived from and depending upon, the price of an underlying asset.

Credit Derivatives Definition

As per Wikipedia, credit derivative refers to any one of various instruments and techniques designed to separate and then transfer the credit risk or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debt holder. Simply explained it is the transfer of the credit risk from one party to another without transferring the underlying.

They are the negotiable bilateral contracts (reciprocal arrangement between two parties to perform an act in exchange of the other parties act) that help the users to manage their exposure to credit risks. The buyer pays a fee to the party taking on the risk.

Types of credit derivatives

1. Unfunded credit derivatives.
2. Funded credit derivatives.

Unfunded credit derivatives: It is a contract between two parties where each is responsible of making the payments under the contract. These are termed as unfunded as the seller makes no upfront payment to cover any future liabilities.  The seller makes any payment only when the settlement is met. Ultimately the buyer takes the credit risk on whether the seller will be able to pay any cash / physical settlement amount. Credit Default Swap (CDS) is the most common and popular type of unfunded credit derivatives.

Funded Credit derivatives: In this type, the party that is assuming the credit risk makes an initial payment that is used to settle any credit events that may happen going forward.  Thereby, the buyer is not exposed to the credit risk of the seller. Credit Linked Note (CLN) and Collateralized Debt Obligation (CDO) are the charmers of the funded credit derivative products. These kinds of transactions generally involve SPVs for issuing / raising a debt obligation which is done through the seller. The proceeds are collateralized by investing in highly rated securities and these note proceeds can be used for any cash or physical settlement.

Products under each type

UNFUNDED CREDIT DERIVATIVES

A. Credit default Swap (CDS):

The most popular form of unfunded credit derivative is Credit Default Swap (CDS).

In a credit default swap, the seller negotiates an upfront or continuous fee, in order to compensate the buyer when a specified event, such as default or failure to make a payment occurs.

The benefit to the buyer and the seller in CDS is that the buyers can remove risky entities from their balance sheets without having to selling them while the sellers can gain higher returns from investments by entering markets which are otherwise difficult for them to get into.

CDS are mainly of four types:

Credit default swaps on single entities: In this form,  the swap is on a single entity

Credit default swaps on a basket of entities: In this the swap is on a bunch of entities combined

Credit default index swaps: this includes a portfolio of single entity swaps

First-loss and tranche-loss credit default swaps: In this type, the buyer is compensated for any losses from the credit events unlike that in the first loss credit default swap which only compensates the loss from the first credit event

Finally, the value of a default swap depends on the probability of entity or the counterparty or the correlation between them.

Example of CDS

The most common example for a CDS is between a company, bank and Insurance firm:

Suppose Bank A buys a bond which issued by a XYZ Company. In order to hedge the default of XYZ Company, Bank A buys a credit default swap (CDS) from Insurance Company. The bank keeps paying fixed periodic payments to the insurance company, in exchange of the default protection.

B. Credit default swaption:

Credit default swaption or credit default option is an option to buy protection (payer option) or sell protection (receiver option) as a credit default swap on a specific reference credit with a specific maturity. (Wikipedia).

Simply put it is an option on a CDS. It gives the holder a right and not obligation to buy / sell protection for an entity for specified future time period.

C. Credit spread option:

A credit spread, or net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit. (Wikipedia)

D. Total return swap:

It is defined as the total transfer of both the credit risk and market risk of the underlying asset. The assets commonly are bonds, loans and equities.

E. CDS index (CDSI) products

It is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities. CDSI is a standardized credit security unlike a CDS which is an OTC derivative. 

F. Asset backed CDS (ABCDS):

The reference asset in this case is an asset backed security rather than any corporate credit instrument.

FUNDED CREDIT DERIVATIVES

A.CREDIT LINKED NOTE (CLN):

It is structured as a security with an embedded CDS allowing the issuer to transfer a specific credit risk to credit investors. In this case the issuer is not obligated to repay the debt if a specified event occurs. The ultimate purpose of the CLN is to pass on the risk of specific default to the investors who are willing to bear the risk in return for higher yield.

B. Constant Proportion Debt Obligation (CPDO):

CPDO is a complex financial instrument, invented in 2006 by ABN Amro and designed to pay the same high interest rate as a risky junk bond while offering the highest possible credit rating. It is defined as a type of synthetic collateralized debt instrument that is backed by a debt security index. These are credit derivatives for the investors who are willing to take exposure to credit risk.

C. Collateralized debt obligation (CDO):

It is a type of structured asset backed security (ABS). The CDO is divided into tranches through which the flow of payments is controlled. The payments and interest rates vary with the tranches with the most senior one paying the lowest rates and the lowest tranche paying the highest rates to compensate for the default risk. Synthetic CDOS are credit derivatives that are synthesized through basic CDs like CDSs and CLNs. These are divided into credit tranches based on the level of credit risk.

Benefits & Risks of Credit Derivatives

Conclusion

With the set of pros and cons involved in credit derivatives, investors should measure and manage counterparty risks, correlations and liquidity. Building a strong financial shock absorber is a key element for ensuring financial stability.