One of the most important contributions of credit derivatives is that they have made it possible to effectively hedge credit risk. Consider the following applications:
Cash market credit portfolio.
A high yield fund can hedge the fund's exposure to a macro market credit spread widening by entering into an index swap where the fund pays the total return on the Merrill High Yield Master Index and receives the Merrill Government Master Index. The swap allows the manager to get "short" high yield credit spreads without altering the duration of his portfolio.
Hedging counterparty exposures.
The growth of interest rate derivatives has lead financial institutions and corporations to manage their exposure to derivative counterparties. A firm can enter into a contingent default swap under which the default swap is only in effect during those scenarios when the exposure is significant, thereby gaining credit protection for adverse scenarios at a lower cost than normal default protection.
Business risks
. Manufacturers that sell to retailers have concentrated credit exposure to a single industry. Many utilize "factors", credit intermediaries that provide a guarantee of payment on each shipment. Because of limited capital and lack of business diversification in the factoring industry, pricing of receivables credit insurance, when available, is often significantly higher than capital markets credit pricing. As an alternative, manufacturers can purchase first loss credit protection against an entire portfolio of receivables in the form of default options linked to more liquid corporate bonds.
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