■ 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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