Credit Derivatives Meaning Types Risks Swaps Examples

Credit Derivatives Meaning

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CDs are extensively used in the commercial banking sector across the US. The banks use them to mitigate credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more exposure and expand their credit portfolio. In addition, insurance companies also use them to improve returns on their asset portfolio. CDs are traded over the counter, and their price depends on the borrower’s credit rating.

Key Takeaways

Credit derivatives (CDs) are a type of derivatives instrument that allows the transfer of credit risk from a lender to a third party against payment of a fee.Credit risk is the risk of loan or debt default.There are three parties to a credit derivative contract: borrower (reference entity), lender (protection buyer), and third party (protection seller).Credit derivatives may be funded or unfunded. They include credit default swap, credit spread option, credit linked note, and collateral debt obligation.CDs are the buffer against economic volatility.

Credit Derivatives Explained

Lenders or investors possess varying degrees of risk toleranceRisk ToleranceRisk tolerance is the investors’ potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor’s age, income, investment objective, responsibilities and financial condition.read more. Debt securities come with several types of risk: interest rate, liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, credit, prepaymentPrepaymentPrepayment refers to paying off an expense or debt obligation before the due date. Often, companies make advance payments for expenses as well as goods and services to shed their financial burden. Advance payments also act as a tool to attain monetary benefits. Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.read more, etc. To hedge them, investors enter into a derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based.read more. Derivatives are financial instruments that confer the same value as their underlying financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more to the holder without the right of ownership over them.

Therefore, a credit derivative is a type of derivativeType Of DerivativeA derivative is a financial instrument whose structure of payoff is derived from the value of the underlying assets. The three types of derivatives are forward contract, futures contract, and options.read more contract that derives its value from the underlying debt instrumentDebt InstrumentDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more and is used to protect the lender against credit risk. Credit risk means the risk that borrowers may default on their loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more or debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more obligations.

To reduce the potential credit risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Lossread more related to risky borrowers, lenders enter into a CD with a third party (counterpartyCounterpartyA counterparty in a financial transaction is the person or entity on the other side of the agreement. Any trade must have at least two parties who serve as counterparties for each other. For every buyer in a purchasing deal, there must be a seller. And for every seller, there must be a buyer willing to purchase.read more) for selling debt securities without the transfer of their ownership. The counterparty guarantees to cover the default on a loan or debt on behalf of the borrower in return for a certain sum.

Thus, if the loan account defaults, the lender gets the securities’ value repaid as per the credit derivative agreement. But if the loan account comes to a successful closure, the counterparty gets to keep the exorbitant fees it charges for providing the insurance to the loan.

How do the Credit Derivatives Function?

A CD involves mainly three participants:

The borrower who needs credit (reference entity)The lender who needs insurance for the loan (protection buyer)The third party or the guarantor who wants to profit by covering the risk of a loan default (protection seller/counterparty)

Let us suppose that the borrower, an XYZ Coffee Shop, needs a credit line of $100000 for developing its business. However, the firm has an unhealthy credit rating amongst financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.

Now, suppose the XYZ Coffee Shop applies for the credit of $100000 from the ABX Bank. In that case, it will face a hurdle in securing the loan from the bank owing to its bad credit record.

In this case, the bank will issue the loan. However, it will enter into a contract with a third party to mitigate the credit risk associated with the loan. Such a contract is referred to as a credit derivative.

Here, ABX Bank is the protection buyer, the third party is the protection seller, and XYZ is the reference entity. ABX will have to pay a certain fee to the third party in lieu of covering the risk of loan default for the term of the CD contract.

The value of the CD will depend on the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of the reference entity and the third party. The CD will enable the bank to transfer the entire loan default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more to the guarantor or the third party.

Therefore, if the XYZ coffee shop defaults on its loan, the third party will pay the remaining amount or the interest of the loan to the bank and close the loan. However, if the XYZ Coffee shop doesn’t default upon its loan, the third party retains the fees on the CD contract.

Hence, in the light of the above explanation, we can see that the CD has:

Enabled the credit line to the XYZ Coffee ShopCovered the credit risk of the loan account of the ABX bank andBenefitted the third party in terms of fees received from the ABX bank

Types of Credit Derivatives

CDs are useful instruments for offloading a lender’s credit risk to a third party and securing its credit asset. There are two main categories of CDs: Unfunded and Funded.

#1 – Unfunded Credit Derivatives

Unfunded CDs are instruments where the protection buyer (lender) does not receive any initial payment from the protection seller (counterparty) for covering the credit risk. Under such a contract, the counterparty pays only when the borrower defaults. Therefore, unfunded CDs expose the lender to the risk of default from the counterparty.

There are different types of unfunded CDs.

Credit Default Swap (CDS)

In this type of contract, both the protection seller as well as the protection buyer of the credit asset negotiate a deal where:

The buyer undertakes to make regular payments (swap spread or premium) to the seller over the term of the contract, andThe seller makes good the loan in the event of default by the borrower or reference entity.

It is the most popular derivate product, widely used in the commercial banking sector.

Credit default swap option

It is a contract that offers its buyer a right, without obligation, to enter into a CDS agreement on a future date at a specific strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

Credit spread option

This type of CD involves simultaneously buying and selling an option of the same class (with the same underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more and expiry date) at a different strike price. The difference in the strike prices yields profit.

Total-rate-of-return swap

It involves the transfer of both credit and interest rate risksInterest Rate RisksThe risk of an asset’s value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more associated with the underlying financial asset to a third party. Here also, the transfer of risk is without the transfer of the ownership of the underlying asset.

#2 – Funded Credit Derivatives

Funded CDs are instruments where the lender is not exposed to the credit risk from the counterparty. This is because the counterparty pays an appropriate sum to the lender to cover any loan default in the future. Now, let’s discuss the different types of funded CDs.

Credit linked note (CLN)

It is a type of funded CD that allows the protection seller to transfer a specific set of its credit risk to a third party (investor in the note). If the borrower doesn’t default, the note is redeemed at par at maturity. However, if the default occurs, it is redeemed at less than the par valuePar ValuePar value is the minimum value of a security set and stated in the corporate charter or its certificate by the issuer when issued for the first time.read more.

Constant Proportion Debt Obligation (CPDO)

It is a type of CD that allows the investors exposure to credit risk through a note that has the credit rating embedded in it. This is done to utilize the dynamic leveraging of trades. CPDO offers high yields with low credit risk.

Collateralized debt obligation (CDO)

It is a form of CD where banks collect all their loans and make a bundle that acts as debt instruments. These instruments are backed by an asset or collateral security and then sold to the investors in small parts after splitting them into tranchesTranchesTranches refer to the segmentation of a pool of securities with varying degrees of risks, rewards, and maturities to appeal to investors.read more. They are only available for sale to institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more.

Examples of Credit Derivatives

Example #1

Let us assume that Lehmann Brothers (LB) purchases bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more issued by General Electric (GE) in large amounts. LB expects GE to pay some good returns on its bonds semi-annually. But LB is afraid that if GE goes bankrupt, it will lose money.

So, LB decides to buy credit default swapsCredit Default SwapsA Credit Default Swap (CDS) is a financial agreement between the CDS seller and buyer. The CDS seller agrees to compensate the buyer in case the payment defaults. In return, the CDS buyer makes periodic payments to the CDS seller till maturity.read more (CDS), a form of CD, from AIG in order to secure its investment based on GE bonds. Thus, if GE goes bankrupt, LB will get its investment from AIG. But, on the other hand, if GE never fails, it keeps getting the returns from GE. However, it has to forgo the amount it paid as a premium for the CDS.

Example #2

Suppose a company XYZ is issuing a bond with a $1 million par value and 7% coupon rate. ABC Bank has excess funds at its disposal and is willing to invest in XYZ bond. However, XYZ is rated low by the credit rating agencyCredit Rating AgencyCredit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and their issuers, including companies and countries.read more. Therefore, ABC bank seeks a credit default swap (CDS) from MNM to mitigate its exposure to credit risk.

ABC will pay 1% of the face value of the bond (fees) to MNM in return for its insurance against XYZ’s default. If XYZ defaults, ABC (CDS buyer) will get a payment from MNM (CDS seller). However, if XYZ doesn’t default, MNM stands to benefit as it gains the fees without covering for any default.