Credit derivative instruments are simply financial contracts that facilitate credit risk transfer
Credit derivatives are bilateral financial contracts that transfer credit risk from one counterparty to another. This section offers a brief introduction to each of the main credit derivative products. Credit derivatives take on the form of swaps or options and can be embedded in bonds, notes or securities issued by special purpose vehicles (trusts or companies).
Ccredit derivatives desk is a market maker in the following products:
• Swaps or options with cash flows linked to the default or change in credit spread of an identified asset or basket of assets;
• Total return swaps on bonds, loans, indices or other assets with credit risk; and
• Special purpose vehicle securities (SPVs) that embed credit risk or tranche credit risk by tenor or seniority.
In Table, we show the primary risks that are transferred by a given credit derivative product.
Table : Credit Derivative Products and Risks Transferred
Primary Risks Transferred Products
Credit risk Default Swaps
Credit and spread risks Credit Spread Options
Putable, Callable and Remarketed Asset Swaps
Credit, spread and correlation risks Portfolio Default Swaps
Synthetic CDOs
Credit, spread and interest rate risks Total Return Swaps
Index Swaps
Synthetic Zero Coupon Bonds Synthetic Callable Bonds
CBOs and CLOs
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Credit derivatives help corporations manage indirect costs related to their business activities.
Reduce interest expense.
Issuers can synthetically tender for their bonds. The synthetic tender provides the economics of a long position in a company's own bonds without the potentially negative tax and book consequences that can accompany a cash market repurchase. Additionally, the synthetic tender provides cheap leverage while maintaining liquidity.
Regulatory Arbitrage.
Currently, the capital charges imposed on banks for the types of credit risks held on their books is not commensurate with the specific credit risk. For example, all unsecured corporate credit obligations are 100% risk weighted by the BIS. Banks can reduce the capital charge by hedging a high-rated, low margin exposure using a default swap with regulated broker dealer counterparty.
Tax management.
An insurance company with a large capital gain in a corporate bond position can hedge the gain by using (paying) a total return swap on the bond and receiving a floating rate cash flow. This hedge is effectively equivalent to a sale of an asset with a gain, but a tax event is averted since the bond is not sold.
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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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