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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