■ Credit Linked Notes
Default swaps are off-balance sheet, leveraged instruments that offer unique advantages due to their derivative qualities. However, a distinct portion of the credit linked notes investor community is unable to take advantage of derivative products and must
keep all instruments in funded, on-balance sheet vehicles. This segment of the investor community can access the default swap market with credit linked notes.
Credit linked notes are created by combining credit default swaps with highly rated corporate and asset-backed bonds to create a separate investment vehicle. The credit linked note is exposed primarily to the reference credit with some incremental risk added by the underlying collateral.
■ Cancelable Default Swaps
Cancelable Default Swaps are default swaps with an embedded option for the protection buyer to terminate the default swap early. The cancelable default swap performs identically to a standard default swap if the option is never exercised. If the option is exercised, a final accrued payment is delivered and the swap is terminated.
The early termination option is a benefit to the protection buyer as it gives the right to cancel future payments at zero cost. Early termination of standard default swaps is accompanied by a mark-to-market cost in addition to any accrued payments. The option is paid for through incremental premium over and beyond the standard default swap premium.
Cancelable Default Swaps are excellent ways for companies to hedge the credit risk embedded in callable securities. Commercial banks purchase cancelable default protection to hedge bank loans which are generally callable at par. Callable bond investors can cancel their protection payments if the call feature on their underlying bond is exercised.
■ Digital Default Swaps
Digital default swaps involve the payment of a fixed dollar amount from the seller of protection to the buyer upon the occurrence of a credit event. Digital default swaps normally employ a smaller number of credit events in order to mitigate the potential for technical credit events.
Digital default swaps are used to hedge exposures such as preferred stock, operating leases and counterparty exposures, which will not generate a substantial claim on a defaulted borrower. Digital default protection is also used to hedge debt instruments such as Paris Club trade debt, which is non-transferable.
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Applications
Default swaps are a basic building block of credit derivatives. One significant credit derivative products advantage to using default swaps in managing credit risk is the increased flexibility. Default swaps can be customized to meet specific tenor and payout requirements. Many parties use default swaps to reduce credit risk associated with illiquid or non-transferable assets, as shown in the examples below.
Buyers of Protection
• Banks use default swaps to reduce regulatory capital. If a corporate bank loan is hedged through a default swap with another bank or other 20% risk-weighted institution, the bank buying protection is able to reduce the amount of regulatory capital held from 8.0% to 1.6%. The Federal Reserve has provided guidelines as to what constitutes an effective hedge (see section entitled "Regulatory Treatment of Credit Derivatives").
• Corporations use default swaps to hedge business risks, such as supply contracts and receivables. If a Credit Event occurred the default swap would provide a payout which would offset the loss on the receivables or the mark to market value of the supply contracts.
• Commercial banks use default swaps to reduce their exposure to a particular credit without damaging long standing relationships. The default swap provides an offsetting hedge to any on-balance sheet loans, effectively nullifying the credit exposure without necessarily notifying the reference entity to whom the original loans were issued.
Sellers of Protection
• Insurance companies currently assume credit risk through the purchase of corporate bonds financed with guaranteed investment contracts, the sale of bond insurance, and the issuance of guarantees such as surety policies. Selling default protection is analogous to the above and delivers higher returns and alternative sources of capital.
• Money managers seek short-dated credit exposure while borrowers tap the capital markets for long-dated financing. Selling default protection delivers the short-dated credit risk of the bank loan market, convertible bond market and vendor financing markets to these investors.
• [Corporate bond investors under-allocated on a primary bond offering write default swaps on the reference credit. The default swap allows the insurance company to realize the full desired exposure to the underlying company. The insurance company can allocate resources to tracking and managing the credit without worrying about its ability to get exposure to the credit.]
• Commercial banks sell credit protection to diversify their portfolio and finance the purchase of protection on concentrated exposure.
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Credit default swaps (default swaps) transfer the credit risk of an issuer from one party to another. The party buying protection pays a premium to the party providing protection; in exchange, the party providing protection agrees to pay an amount to the other party upon the occurrence of a credit event with respect to the issuer.
Default swap contracts have the following important terms:
Reference Debt Obligation.
The default swap contract will define the Reference Debt Obligation. This can be a bond, loan, swap contract, or any debt obligation of the Reference Credit. This section should provide for successors to the Reference Credit as well as a process to choose replacement debt obligations if the Reference Debt Obligation is called, prepaid, or otherwise ceases to exist any time during the life of the contract.
Credit Event or the Event of Default.
There are at least three choices for definition of the Credit Event:
(a) market convention, which is a four-part definition including forced acceleration, payment default, major debt reorganization or a bankruptcy;
(b) an Event of Default under the Reference Debt Obligation; or
(c ) ISDA's draft standard which is similar to (b) but more extensive.
The primary concern of both parties should be to choose a definition that excludes "minor" or technical defaults. The party providing protection would not want a false trigger to cause them to make a payment; likewise, the party buying protection would not want to forfeit that protection on the occurrence of a non-substantive default.
Materiality
. Some transactions require that for a Credit Event to have occurred, a minimum price deterioration (known as a materiality threshold) in the underlying asset should have occurred. This threshold assures the protection buyer that he will not loose the credit protection if the market deems the credit event to be immaterial.
Payout.
Following a credit event with respect to the underlying reference credit, the party providing protection will either agree to buy the underlying asset (if the transaction is physically settled) or will make a cash payment (cash settlement). Cash settlement is typically an amount equal to the par amount of the underling debt obligation less the then current market value of the defaulted obligation, as determined by market bids. Due to liquidity issues after default, physical settlement is the current market standard. An alternative payout structure is a "digital" payout, equal to a fixed amount of the notional, usually 100%.
The premium of a default swap
Price or premium. The party providing the credit protection receives a swap is usually near the asset swap premium. This premium is agreed upon between the two parties and will generally level of comparable cash asset be near spreads achievable in conventional markets for assuming floating rate
exposures on the Reference Credit for the tenor of the default swap.
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