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Meaning of Credit Linked Notes

Certain investors are prevented from entering into derivatives contracts, either by law or by internal investment policies. Credit Linked Notes (CLNs) allow such investors to derive some of the benefits of credit derivatives.

Credit Linked Notes (CLNs) are regular debt obligations with an embedded credit derivative. They can be issued either directly by a corporation or bank or by highly rated special purpose vehicles created by dealers. The coupon payments made by a CLN effectively transfer the cash flow of a credit derivatives contract to individual investors.

Credit Linked Notes are best understood by a simple example: ABC Investments would like to take on the risk associated with the debt of XYZ Corp., but all of XYZ’s debt is composed of bank loans and ABC Investments cannot simply sell protection in a Credit Default Swap (CDS) because its investment policy prevents it from entering into a derivatives contract. Let us assume that the size of ABC Investments desired exposure to XYZ Corp.…

The credit default swap (CDS) is the cornerstone of credit derivatives market. A credit default swap is a swap contract in which protection buyer (buyer of CDS) makes a series of payments over the maturity of CDS to the protection seller & in exchange receives a payment which is contingent on the happening of default by third party (reference entity). In short, it is a credit derivative contract between two parties in order to exchange the credit risk of an issuer (reference entity). The underlying (reference) asset can be bond or loan of any corporation known as reference entity. The reference entity is not a party to the contract. Reference entity refers to the party on which protection is written. The protection buyer makes quarterly premium payments (spreads) to the protection seller. This premium is usually some percent of notional value of CDS contract, expressed in basis points. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash, with the settlement choice determined upfront when entering into the contract.…

Rationale for Introducing Credit Derivatives

Our present society lives on credit. Credit allows us to consume far more than what our savings can sustain. Therefore, credit is the very basis of consumerism. Our economy drives on the basic force of credit. What exactly is credit? Credit is parting with value today against a promise for value in future and this credit has inherent risk in it which is known as credit risk. Credit risk is the risk that the promise of payment in future may be broken. In other words, credit risk is an investor’s risk of loss arising from a borrower who does not make payments as promised. When the borrower fails to make payments, it is termed as default. So, credit risk is also known as default risk. This concept of credit risk can be looked at from two perspectives. Credit risk on the loans granted by banks and also on the bonds issued by corporate. In case of banks, credit risk occurs when the borrower defaults on loan repayment and in the event of default, the lender (bank) suffers from a loss.…

Instead of Price Earning (P/E) Ratio many investment analysts prefer to look at price cash flow ratio. A Price to Cash Flow Ratio is measured as the company’s current stock price divided by its current annual cash flow per share.

Price/Cash Flow Ratio = Price Per Share / (Cash Flow / Shares Outstanding)

There are varieties of definitions of cash flow. In this context, the most famous measure is simply calculated as net income plus depreciation. Cash flow is usually reported in firm’s financial statement and labeled as cash flow from operations.

The difference between cash and earnings is often confusing largely because the way standard accounting practice defines net income. Essentially net income is measured as incomes minus expenses. Obviously this is logical. However not all are actual cash expenses. The most important exception is depreciation.

When a firm acquires a long-lived asset such as new factor facility, standard accounting practice does not deduct the cost of the factory at all once, even though it is actually paid for all at once.…