Credit Derivatives Final

Presented by : Abhishek Kr. Singh Sakhee Gandhi

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

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

Market Size International Swap and Derivative Association

reported in april 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion "Worldwide credit derivatives market is valued at

$62 trillion".

1. Un funded Credit derivatives -Credit Default Swap -Credit Spread Options

2. Funded Credit Derivatives -Credit Linked Notes

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.

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.

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.

Example Refer 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 creditlinked 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.

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

Buyer s

Banks Hedge Funds I nsur es/ Rei nsur er s Pensi on Funds

Secur i t i es Fi r ms Cor por at es Mut ual Funds Gover nment

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 Participants Source:British Bankers Association (BBA)

Sel l er s

Secur i t i es Fi r ms Gover nment Mut ual Funds Cor por at es

Banks Pensi on Funds I nsur es/ Rei nsur er s Hedge Funds