Introduction To Credit Derivatives

Stephen P. D’Arcy and

Xinyan Zhao
What are Credit Derivatives?

“Credit derivatives are derivative instruments

that seek to trade in credit risks. ”

http://www.credit-eriv.com/meaning.htm
What are Derivatives?

A financial contract that has its price derived

from, and depending upon, the price of an
underlying asset.

The underlying assets might be traded.

Types of Derivatives include, Swaps, Options

and Futures for example.
What is Credit Risk?

The risk that a counterparty to a

financial transaction will fail to fulfill their
obligation.
Growth in Credit Derivatives

Source:BBA Credit Derivatives Report 2006

 Types of credit
derivatives
– Credit default swap

– Credit spread option

– Credit linked note

What is Credit default swap?

Credit default swaps allow one party to "buy" protection

from another party for losses that might be incurred as a
result of default by a specified reference credit (or
credits).

The "buyer" of protection pays a premium for the

protection, and the "seller" of protection agrees to make
a payment to compensate the buyer for losses incurred
upon the occurrence of any one of several specified
"credit events."
Example
Suppose Bank A buys a bond which issued
by a Steel Company.

To hedge the default of Steel Company:

Bank A buys a credit default swap from

Insurance Company C.

Bank A pays a fixed periodic payments to C,

in exchange for default protection.
Exhibit
Credit Default Swap

Credit Risk

Premium Fee
Insurance Company C
Bank A Buyer Contingent Payment On Seller
Credit Event

Steel company
Reference Asset
 What is credit spread option?

A credit spread option grants the buyer the right, but

not the obligation, to purchase a bond during a
specified future “exercise” period at the
contemporaneous market price and to receive an
amount equal to the price implied by a “strike spread”
stated in the contract.
Credit Spread

The different between the yield on the borrower’s

debt (loan or bond) and the yield on the referenced
benchmark such as U. S. Treasury debt of the same
maturity.
Example

An investor may purchase from an insurer an option

to sell a bond at a particular spread above LIBOR
Credit spread.

If the spread is higher on the exercise date, then the

option will be exercised. Otherwise it will lapse.
Exhibit
Profit

Strike price
Spot price
Credit-linked notes

A credit-linked note (CLN) is essentially a funded

CDS, which transfers credit risk from the
note issuer to the investor.

The issuer receives the issue price for each CLN

from the investor and invests this in low-risk collateral.

If a credit event is declared, the issuer sells the

collateral and keeps the difference between the face
value and market value of the reference entity’s debt.
Example
Refer to the Steel company case again.

Bank A would extend a $1 million loan to the Steel

Company.

At same time Bank A issues to institutional investors

an equal principal amount of a credit-linked note,
whose value is tied to the value of the loan.

If a credit event occurs, Bank A’s repayment

obligation on the note will decrease by just enough to
offset its loss on the loan.
Exhibit

$1 Million

Bank A Institutional investors

fixed or floating
coupon,if defaults or
declares bankruptcy the
investors receive an
$1million

500b p
amount equal to the
Steel recovery rate

Company

Steel Company
 Credit Derivatives Market
Participants
Source:British Bankers Association (BBA) 2003/2004 Credit Derivatives Report

Buyer s

Banks Secur i t i es Fi r ms
Hedge Funds Cor por at es
I nsur es/ Rei nsur er s Mut ual Funds
Pensi on Funds Gover nment
For the protection buyer
(the risk seller)
– to transfer credit risk on an entity without
transferring the underlying instrument
– regulatory benefit
– reduction of specific concentrations portfolio
management
– to go short credit risk
Credit Derivatives Market
Participants
Source:British Bankers Association (BBA)

Sel l er s

Secur i t i es Fi r ms Banks
Gover nment Pensi on Funds
Mut ual Funds I nsur es/ Rei nsur er s
Cor por at es Hedge Funds
For the protection seller
(the risk buyer)
– diversification
– leveraged exposure to a particular credit
– access to an asset which may not
otherwise be available to the risk buyer
sourcing ability
– increase yield
Questions

1. Does your bank use credit

derivatives? If yes,

a. What type?
b. How long?
c. What is the primary purpose?
2. Do you think that most bankers in
China understand credit derivatives?
If not,

a. What could help them understand

credit derivatives better?
b. What would be the most effective
way to help?
3. Do you think banks in China should
use credit derivatives to manage credit
risk?

a. What problems need to be solved to

improve risk management?
b. Do regulations need to be changed?