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The main specifics of credit derivatives are:

• The underlying assets.

• The payment terms.

• The value of payments under a credit event.

• The conditions defining a credit event.

• The risk materialization.

• Legal issues with respect to risk transfers.

Underlying Assets

The credit derivative contracts exchange payments triggered by a credit event of an underlying asset or a basket of assets. The credit event can be a loss in value, a downgrade or a default. The underlying asset can be a bond, a loan or any credit asset, including baskets of assets. There is no need for the asset to be tradable, although observable prices facilitate the valuation of the asset under no default or under default, as well as the measurement of credit risk loss in the event of migrations. As with other derivatives, there is a notional amount. The notional amount might be identical to the principal of a loan, or it can differ from the value of the underlying asset. This allows leveraging the transaction. For instance, it is possible to insure the spread of a bond for an amount that is a multiple of the face value of the underlying bonds. This allows speculation and return (or loss) enhancement because the ratio notional/face value of the underlying asset is higher than 1.

Credit derivatives include forward instruments, with a forward start. Such contracts start at a future date, instead of the inception date. The term of the contract differs from the maturity of the underlying. It might be shorter and/or start forward, allowing tailored term structures of exposures. However, it cannot exceed the maturity of the underlying, since the reference would disappear if the contract were longer. This does not apply with an underlying made up of pools of assets, since there might be a permanent structure of the pool agreed in advance.

Payment Terms

The investor or, equivalently, the risk buyer, or protection seller, receives fees from the buyer of protection plus the interest payments of the underlying assets. The buyer of protection, or the risk seller, receives from the investor an interest, such as LIBOR plus some margin. Payments are both periodic and at termination. Termination payments are settlement payments if the credit risk of the underlying actually materializes. They require the definition of the post-default value. When assets are tradable with a reasonable liquidity, prices are a sound basis for calculating the payment. This leads to choosing underlying assets complying with such conditions, or agreeing in advance to a payout payment (such as a fixed amount). In addition, the determination of the price based on securities needs to be transparent, necessitating some polling of dealer prices to have an objective reference.

Legal Issues

The legal separation of the derivatives from the underlying loan or bond allows transferring the risks without prior consent of the borrower. This transfer extends to economic rights related to the borrower obligation. Such an extension raises legal issues since the holder of the total return swap might exercise rights that could affect the profile of the obligation (in case of distress restructuring or any dispute). Because of this issue, the investor might not have directly such information and the right of representation.

Credit derivatives allow transferring risk without transferring the cash assets. This offers potential whenever it is more difficult to transfer assets than credit risk through derivatives. The development of synthetic structures in Europe for off-loading credit risk without sales of assets illustrates the benefit of this differential legal treatment.

The Value of Payments under a Credit Event

There is some initial reference price, either a nominal value for a loan or a bond price, reflecting the current credit standing of the issuer as well as the contractual payments of this asset. Since listed assets do not have a single price, several dealers quotes serve to determine a price. Payments relate to the current value of the asset.

For a credit default option, the buyer and seller agree on the payment value, netted from any recoveries or not. For traded assets, the post-default price defines the loss under default. With total return swaps, payments cumulate the capital appreciation or depreciation with the normal asset return. For credit spread derivatives, the payments are a function of the difference between initial and final credit spreads and need conversion into a value. The value is the difference in spreads times a multiple for converting this change into a price change. The multiplier is the duration since it measures the price sensitivity of a bond to a unit change in discount rate. The determination of the duration requires a rule, because of duration drift across time and because it depends on the interest level.

The relationship to the asset does not imply matching the asset price with the derivative notional. Users can leverage the actual exposure of the underlying by using a notional different from the actual asset value. This allows us to customize the exposure. Lenders can reduce their excess exposures. Investors in credit derivatives can leverage their investment and customize their expected return.

Delivery is in cash, or with securities. The second option raises the usual issue of what to deliver, since the underlying asset might disappear. This requires defining the equivalent assets to deliver in advance.

Credit Events

There are two overlapping categories of credit events: those of the underlying asset credit event and those that trigger a derivative credit event. The second group includes all conditions that trigger exercise of the derivative obligations. The two sets of events normally overlap, but they might differ in practice. The difference might exist because any deterioration of the credit standing of the underlying asset might serve to trigger the derivative obligations. For instance, mergers might weaken the credit standing of firms and be looked at as a potential credit event triggering exercise of a credit derivative, while it is a migration event for credit risk. Furthermore, a merger might not even trigger a migration and still be a credit event for a credit derivative.

For the reference asset, credit events include: payment obligation default; bankruptcy or insolvency event; restructuring or equivalent; rating downgrade beyond a specified threshold; change in credit spread exceeding a specified level; payout event of a structure. Failure to pay is a key credit event. However, a grace period can delay the failure event. Credit events might have a wide scope. Downgrades usually refer to ratings. They differ according to whether they relate to long-term ratings or short-term ratings. Default events are more restrictive than credit events. They relate to any contractual clause that triggers default. The event itself is a payment default obligation or an insolvency event, plus all events that trigger covenants resulting in cross-default and cross-acceleration. Such obligations refer broadly to any borrowings by the reference entity from several lenders. Since they refer to several parties, they are cross obligations.

Materialization

Such events might be difficult to define precisely, because of potential disputes. Materiality clauses help to avoid triggering a false credit event by specifying the observable consequences of a credit event. Common factors are minimum variations of prices or changes in spreads, legal notices and publicly available information. Price materiality refers to a minimum difference between the initial price of the reference asset and the price if the risk materializes. Spread materiality refers to a minimum difference between the spread at inception and the final spread.

However, all are subject to dispute and materialization should be legally acceptable to all parties. This issue is imperfectly solved as of today, although the term sheets of derivative contracts now embed some experience.