Introduction To Credit DerivativesStephen P. D’Arcy and Xinyan Zhao

What are Credit Derivatives?

“Credit derivatives are derivative instruments that seek to trade in credit risks. ”

http://www.credit-eriv.com/meaning.htm

What are Derivatives?

A financial contract that has its price derived from, and depending upon, the price of an underlying asset.

The underlying assets might be traded.

Types of Derivatives include, Swaps, Options and Futures for example.

What is Credit Risk?

The risk that a counterparty to a financial transaction will fail to fulfill their obligation.

Growth in Credit Derivatives

Source:BBA Credit Derivatives Report 2006

Types of credit derivatives

– Credit default swap

– Credit spread option

– Credit linked note

What is Credit default swap?

Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).

The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events."

Example Suppose Bank A buys a bond which issued

by a Steel Company.

To hedge the default of Steel Company: Bank A buys a credit default swap from

Insurance Company C.

Bank A pays a fixed periodic payments to C, in exchange for default protection.

Exhibit Credit Default Swap

Bank A BuyerInsurance Company C

Seller

Steel companyReference Asset

Contingent Payment On Credit Event

Premium Fee

Credit Risk

What is credit spread option?

A credit spread option grants the buyer the right, but not the obligation, to purchase a bond during a specified future “exercise” period at the contemporaneous market price and to receive an amount equal to the price implied by a “strike spread”

stated in the contract.

Credit Spread

The different between the yield on the borrower’s debt (loan or bond) and the yield on the referenced benchmark such as U. S. Treasury debt of the same maturity.

Example

An investor may purchase from an insurer an option to sell a bond at a particular spread above LIBOR Credit spread. If the spread is higher on the exercise date, then the

option will be exercised. Otherwise it will lapse.

ExhibitProfit

Spot priceStrike price

Credit-linked notes

A credit-linked note (CLN) is essentially a funded CDS, which transfers credit risk from the

note issuer to the investor.

The issuer receives the issue price for each CLN from the investor and invests this in low-risk collateral.

If a credit event is declared, the issuer sells the

collateral and keeps the difference between the face value and market value of the reference entity’s debt.

ExampleRefer to the Steel company case again.

Bank A would extend a $1 million loan to the Steel Company.

At same time Bank A issues to institutional investors an equal principal amount of a credit-linked note, whose value is tied to the value of the loan.

If a credit event occurs, Bank A’s repayment obligation on the note will decrease by just enough to offset its loss on the loan.

Exhibit

Bank A Institutional investors

Steel Company

$1 Million

fixed or floating coupon,if defaults or declares bankruptcy the investors receive an amount equal to the recovery rate

$1million

500b p

Steel

Company

Credit Derivatives Market ParticipantsSource:British Bankers Association (BBA) 2003/2004 Credit Derivatives Report

Buyers

Banks Secur i t i es Fi rmsHedge Funds CorporatesI nsures/ Rei nsurers Mutual FundsPensi on Funds Government

For the protection buyer(the risk seller)

– to transfer credit risk on an entity without transferring the underlying instrument– regulatory benefit– reduction of specific concentrations portfolio management

– to go short credit risk

Credit Derivatives Market ParticipantsSource:British Bankers Association (BBA)

Sel l ers

Secur i t i es Fi rms BanksGovernment Pensi on FundsMutual Funds I nsures/ Rei nsurersCorporates Hedge Funds

For the protection seller(the risk buyer)

– diversification– leveraged exposure to a particular credit– access to an asset which may nototherwise be available to the risk buyer sourcing ability – increase yield

Questions

1. Does your bank use credit derivatives? If yes,

a. What type?b. How long?c. What is the primary purpose?

2. Do you think that most bankers in China understand credit derivatives? If not,

a. What could help them understand credit derivatives better?

b. What would be the most effective way to help?

3. Do you think banks in China should use credit derivatives to manage credit risk?

a. What problems need to be solved to improve risk management?

b. Do regulations need to be changed?