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This section provides a broad overview of credit derivatives, what functions they fulfill, who has an interest in them and why.

Functions of Credit Derivatives

Credit derivatives are instruments serving to trade credit risk by isolating the credit risk from the underlying transactions. The emergence of credit derivative instruments is a major innovation because, unlike other risks, such as market or interest rate risk, there was no way, until they appeared, to hedge credit risk.

Hence, the first function of credit derivatives for risk takers is hedging. A credit derivative provides protection against other credit events, such as a downgrade or default event. When such an event occurs, the credit derivative provides a payment to the party suffering the loss from the credit event as classical insurances do. But there are many differences. For example, credit derivatives do not necessarily refer to assets held by the bank. Another difference is that credit events need specifications and defining the amount to pay, since it is not straightforward to value a downgrade or a default, because of recovery uncertainty. In addition, there are various ways to define credit events. For example, default can be delays in payment, restructuring or iling for bankruptcy.

Credit derivatives allow us to separate trade in the credit risk of assets from trade in the assets themselves since, like other classical derivatives, it is possible to trade them without trading the reference assets. Another salient feature of credit derivatives is that they are off-balance sheet and do not necessitate entering directly into loan arrangements or purchases of bonds, nor do they necessitate the prior agreement of the issuer of the reference asset. This is why so many synthetic securitizations, structured with credit derivatives, developed in Europe, because such agreements are not yet usual.

The products are generally classified into three broad groups: total return swaps, credit spread products and credit default products. In a total return swap, the protection seeker exchanges the total return of an asset, which combines both current revenues and capital gains or losses, with a fee paid to the protection seller. This provides a protection against a downside move of the value of the reference asset. The investor looks for an enhanced return. Credit spread derivatives exchange a risky spread against the risk-free rate, or a risky spread against another. The protection provider, or investor, looks for enhanced revenue, while the buyer seeks protection against a loss of asset value due to a widening of credit spreads. Credit default products offer payment in the event of default of a reference asset. If the protection provider is rational, he does not believe the event likely enough to absorb the enhanced revenue from the sale of the instrument. The two parties are:

• The protection seller who sells the credit derivative.

• The protection buyer who pays a premium and/or fees to the protection seller, in exchange for the protection.

The terms of buyer and seller are best thought of as buyer of protection and seller of protection. Alternatively, buying risk means selling protection, and selling risk means buying protection. The terminology is confusing because it often refers to traditional derivatives. For example, premiums paid to get a payment in the event of default suggest more an option than a swap, although the contract is an obligation. In addition, premiums apply for credit swaps, but they are fees and spreads exchanged during the contract life.

Views on Credit Derivatives

Credit derivatives serve for various players, who view them from different angles. Under the insurance view, the credit derivative market is like a market of protections, transferring credit risk between buyers and sellers of credit derivatives. Investors look at these instruments as providing some return enhancements through the revenue attached or as a technique for replicating exposures to which they have no direct access, as well as trading credit exposures.

Insurance View

Credit derivatives look like insurances. They require a regular payment to provide protection against events whose materialization has a perceived low probability. If the event such as a default occurs, the insurer pays the loss given default, net of recoveries. The triangle of insuring credit risk brings together a protection seller, a protection buyer and the underlying reference assets. The intermediate player making the market is the protection seller (Figure 58.1).

Banks and financial institutions are seekers of protection against credit risk. Corporate entities might use these instruments because they need protection from their customers, especially big customers with whom they have large contracts. Sovereign risk is a case where the size of risk exposure is large enough to warrant a specific protection. All parties are also interested in unbundling the risk components of assets, such as credit and country risks, otherwise tied together in the same loans.

Other Views

Under the investors view, the market looks at these instruments as promising an attractive and enhanced return when credit events are perceived as having a low probability. The search for yield increases when spreads narrow. If an investor can get a high spread with these instruments, it makes them attractive in spite of default risk. Conversely, when the price of credit risk increases, credit derivatives might be less attractive because they become likely to be in-the-money. Under the risk management view, credit derivatives serve to take or shape credit risk and return, both from a buyers view and a sellers view of credit derivatives.

The buyer of credit risk actually gains exposure to the risk of the underlying assets. This replicates the risk through an off-balance sheet instrument, so that the exposure is only notional. In addition, buying and selling risk implies the transfer, full or partial, of credit risk. Transferring risk can be of mutual interest. Two banks, one heavily concentrated in industry A and the other in industry B, might be willing to exchange, or transfer, their risks to each other in order to achieve a better balance of their portfolios. In addition, the parties are sensitive to the revenue effect of credit risk derivatives.

In general, through the trading of credit risk, credit derivatives serve for replicating, transferring or hedging credit risks. Simultaneously, trading risks shapes the returns because of the related revenues or costs. The players have other motives than insurance, such as adding value to portfolios by trading credit risk separately, managing credit risk of investments or participating indirectly in the loan market. Credit risk derivatives also facilitate arbitraging the price of credit risk across transactions of market sectors. The market of credit risk is such that expectations about what the credit spreads or the recovery rates should be are heterogeneous. This creates opportunities to arbitrage market spreads against an investors expectations.