Within the credit derivative spectrum, each product is in a different stage in the product life cycle (See Chart). An instrument's position in the product life cycle illustrates its relative standardization, liquidity and growth potential. Those products at the introduction and growth stages typically have higher investor profit potential yet are less liquid than products in the maturity stage.
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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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