Credit derivative

Overview of Credit Derivatives

A credit asset is the extension of credit in some form: normally a loan, accounts receivable, installment credit or financial lease contract.

Every credit asset is a bundle of risks and returns: every credit asset is acquired to make certain returns on the asset, and the probability of not making the expected return is the risk inherent in a credit asset. The credit asset may, of course, end up in a full or partial loss, which is also a case of volatility of return in that the return is negative.

There are several reasons due to which a credit asset may not end up giving the expected return to the holder: delinquency, default, losses, foreclosure, prepayment, interest rate movements, exchange rate movements, etc.

A credit derivative contract intends to create a trade in either some risk, or all the risk of volatility of return in a credit asset, without transferring the underlying asset. For example, if Bank A enters into a credit derivative with Bank B relating to a loan sitting on the balance sheet of Bank A, Bank B bears the risk, of course for a fee, inherent in the asset held by Bank A.

With the exception of holders of default-free instruments such as Treasuries or Gilts, a key risk run by investors in bonds is credit risk, the risk that the bond issuer will default on the debt. To meet the need of investors to hedge this risk, the market uses credit derivatives. These are financial instruments originally introduced to protect banks and other institutions against losses arising from credit events. As such they are instruments designed to lay off or take on credit risk. Since their inception, they have been used by portfolio managers to enhance returns, to trade credit, for speculative purposes and as hedging instruments.

Global market for credit derivatives

The global market for credit derivatives is growing exponentially and now exceeds $4 trillion. As the market expands, an ever-growing range of instruments has become available, ranging from “plain vanilla” credit default swap (CDS) to complex basket trades such as synthetic collateral debt obligations (CDOs). The size of the market has grown incredibly in the last few years. The fastest-growing segment of the credit derivatives arena is the credit default swap (CDS) market.

Credit Risk

Credit risk is the risk that a borrowing entity will default on a loan, either through inability to maintain the interest servicing or because of bankruptcy or insolvency leading to inability to repay the principal itself. When technical or actual default occurs, bondholders suffer a loss as the value of their asset declines, and the potential greatest loss is that of the entire asset. The extent of credit risk fluctuates as the fortunes of borrowers changes in line with their own economic circumstances and the macroeconomic business cycle.

The magnitude of risk is described by a firm’s credit rating. Ratings agencies undertake a formal analysis of the borrower, after which a rating is announced; the issues considered in the analysis include:

• the financial position of the firm itself, for example, its balance sheet position and anticipated cash flows and revenues;
• other firm-specific issues such as the quality of the management and succession planning;
• an assessment of the firm’s ability to meet scheduled interest and principal payments, both in its domestic and foreign currencies;
• the outlook for the industry as whole, and competition within it;
• general assessments for the domestic economy.

Another measure of credit risk is the credit risk premium, which is the difference between yields on the same-currency government benchmark bonds and corporate bonds. This premium is the compensation required by investors for holding bonds that are not default-free. The credit premium required will fluctuate as individual firms and sectors are perceived to offer improved or worsening credit risk, and as the general health of the economy improves or worsens.

Credit Risk and Credit Derivatives

Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered due to credit events. A payout under a credit derivative is triggered by a credit event. As banks define default in different ways, the terms under which a credit derivative is executed usually include a specification of what constitutes a credit event.

The principle behind credit derivatives is straightforward. Investors desire exposure to non-default free sovereign debt because of the higher returns this offers. However such exposure brings with it concomitant credit risk. This can be managed with credit derivatives. At the same time, the exposure itself can be taken on synthetically if for instance, there are compelling reasons why a cash market position cannot be established. The flexibility of credit derivatives provides users a number of advantages and as they are over-the-counter (OTC) products they can be designed to meet specific user requirements.

Credit derivatives, an instrument that emerged around 1993-94, is a part of the market for financial derivatives. Since credit derivatives are presently not traded on any of the organised exchanges, they are a part of the over-the-counter (OTC) derivatives market. Though still a relatively small part of the huge market for OTC derivatives, credit derivatives are growing faster than any other OTC derivative, the reasons for which are not difficult to understand.

The development of credit derivatives is a logical extension of the ever-growing array of derivatives trading in the market. The concept of a derivative is to create a contract that transfers some risk or some volatility. This risk or volatility may relate to the price or performance of a reference asset, event, a market price or any other economic or natural phenomenon. Such trade in risk does not mean a trade in the reference asset. The reference may remain with someone who is a complete stranger to the derivative contract. However, the derivative trade closely mimics and risks and returns of holding the underlying asset, or at least a segment thereof. Thus, derivatives bring about a completely independent trade in the risks/returns of an asset. For example, a trade in options or futures in equities may run completely independent of trades in equity shares.

Credit derivatives apply the same notion to a credit asset. Credit asset is the asset that a provider of credit creates, such as a loan given by a bank, or a bond held by a capital market participant. A credit derivative enables the stripping of the loan or the bond, from the risk of default (or more risks, depending on the nature of the derivative), such that the loan or the bond can continue to be held by the originator or holder thereof, but the risk gets transferred to the counterparty. The counterparty buys the risk obviously for a premium, and the premium represents the rewards of the counterparty.

Thus, credit derivatives essentially use the derivatives format to acquire or shift risks and rewards in credit assets, viz., loans or bonds, to other financial market participants. Like capital market derivatives, credit derivatives make it possible to hold a credit asset, but sack off the risks in holding it and replace the same by either a pure counterparty risk or risk is a safer asset. Reciprocally, credit derivatives make it possible to not hold a credit asset and yet synthetically  create the position of risk and reward in a credit asset or portfolio of assets.

Securitisation

Much of the significance that credit derivatives enjoy today is because of the marketability imparted by securitisation. Credit derivatives would have mostly been a closely-held esoteric market, but for the introduction of securitisation device to commoditise a credit derivative and bring it to the capital market.

Securitised credit derivatives, or synthetic securitisation, is a device of embedding a credit derivative feature into a capital market security so as to transfer the credit risk into the capital markets. In case of synthetic securitisations, the protection against the risk is ultimately provided by the capital markets.

The synthesis of credit derivatives with securitisation methodology has complemented each other. Credit derivatives have acquired a new meaning when they were turned into marketable securities using securitisation techniques; securitisation on the other hand got a new impetus by opening up possibilities of keeping a whole portfolio of credit assets on books and yet transfer the credit risks of the portfolio. Lot of erstwhile securitisers over Europe and Asia are preferring synthetic securitisations to cash transfers.

Credit derivatives have many implications for bank portfolio managers, including the ability to hedge and diversify their portfolio quickly at market prices. Credit derivatives are also useful for the information they provide about the price of pure credit risk, which bank managers can incorporate into their internal pricing decisions. And finally, credit derivatives have become a key feature of securitizations.