A credit derivative is a financial contract in which the underlying is a credit asset (debt or fixed-income instrument). The purpose of a credit derivative is to transfer credit risk (and all or part of the income stream in relation to the borrower) without transferring the asset itself.
A credit derivative serves as a sort of insurance policy allowing an originator or buyer to transfer the risk on a credit asset (of which he may or may not be the owner) to the seller(s) of the protection or counterparties.
Credit derivatives allow banks to diversify their credit portfolios without venturing outside their usual clientele. For example, two banks, one specialising in farm sector credits, the other in industrial sector debt, may swap part of each other’s income streams. Both banks diversify their risks while each benefits from the other’s field of expertise.
Credit derivatives enable their buyers to protect themselves from the risk of counterparty default. Although methods for controlling and managing counterparty risk previously existed, credit derivatives make it possible to truly cut the risk level.
Lenders are not the only ones who use credit derivatives. Borrowers (e.g. bond issuers) may also use them to protect against potential market fluctuations which could result in a worsening of their financing terms.
A credit swap consists of exchanging the income streams of credits or credit portfolios. This type of over-the-counter contract is often established by an intermediary who charges a commission. It has an advantage over securitisation in that the credits remain in their owner’s books and confidentiality is respected.
There are also more standardised contracts in which, for example, income streams generated by a corporate bond are exchanged for those generated by a government security. The spread between the two yields is a precise measure of the bond issuer’s credit worthiness.
Total return swap: This type of contract entails swapping the total return generated by a credit or credit portfolio for a pre-determined fixed rate, which may be indexed to a benchmark market interest rate.
The simplest form of credit spread option is a bond option. A bondholder who wants to protect himself against a price decline can purchase a put on these bonds. *Note: a put or sell option gives its holder the right to sell the underlying at the exercise price over a specified period of time. This is a traditional option on a security.
A bond issuer may also use options to protect himself against rising rates. The risk premium is defined as the difference between the market rate applying to a given issuer or category and the supposedly risk-free rate of Treasury securities. The risk premium is linked to the credit worthiness of the issuing company, as measured by its credit rating. There are options pegged to this risk premium. For example, a company with a “Baa” rating plans to launch a bond issue in a month. Before the launch, the issuing firm would first like to learn what kind of terms it will obtain on the market. The purchase of a call option, priced to the average risk premium of Baa-rated issuers, enables the potential bond issuer to recover the difference between the interest he will pay on the bond and that which he would like to pay, if the risk premium rises above the threshold. NB: this type of option, if exercised, is based on the delivery of the cash value of the underlying and not the security itself.
Credit default swap
In a credit default swap, the protection buyer continues to pay a certain premium to the protection seller to indemnify him against a credit event (payment default or a worsening in the quality of his debtors). Despite its name, this product is more of an option than a swap.
In case of a payment default on a predetermined number of securities in the portfolio, the holder of the contract receives compensation from the protection seller. With this type of contract, an investor accepts the risk of limited losses (if one or two securities default, he receives nothing), but covers himself against major losses.
A protection buyer may also issue a tradable instrument, credit linked notes, to protect himself against credit risk. The investor who buys these notes will suffer a delay or a reduction in payment, should a predefined credit event occur.
A credit linked note is, in reality, a traditional bond combined with a credit option. The bond itself gives the investor the right to receive a regular stream of interest payments and the principal at maturity. The credit option gives the issuer the right to reduce the bond-linked payments, in the event of a pre-determined credit event with significant effect on his own exposure to credit risk. The price at the time of issue is lower, which accounts for the appeal to investors.