In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counter-parties to the transaction itself. This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt. Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.
Similar to placing a bet at the racetrack, where the person placing the bet does not own the horse or the track or have anything else to do with the race, the person buying the credit derivative doesn’t necessarily own the bond (the reference entity) that is the object of the wager. He or she simply believes that there is a good chance that the bond or CDO in question will default (go to zero value). Originally conceived as a kind of insurance policy for owners of bonds or CDO’s, it evolved into a freestanding investment strategy. The cost might be as low as 1% per year. If the buyer of the derivative believes the underlying bond will go bust within a year (usually an extremely unlikely event) the buyer stands to reap a 100 fold profit. A small handful of investors anticipated the credit crunch of 2007/8 and made billions placing “bets” via this method.
Where credit protection is bought and sold between bilateral counter-parties, this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle(SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative. For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.
Types of Credit Derivatives
Some of the fundamental types of credit derivatives are credit default swap, total return swap, credit linked notes, and credit spread options.
- Credit Default Swaps: A credit default swap (CDS) is a credit derivative contract between two counter-parties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. Credit default swaps are the most important type of credit derivatives in use in the market. Credit default swaps are explained in detail in next chapter.
- Total Return Swaps: As the name implies, a total return swap is a swap of the total return out of a credit asset swapped against a contracted prefixed return. The total return out of a credit asset is reflected by the actual stream of cash-flows from the reference asset as also the actual appreciation/depreciation in its price over time, and can be affected by various factors, some of which may be quite extraneous to the asset in question, such as interest rate movements. Nevertheless, the protection seller here guarantees a prefixed spread to the protection buyer, who in turn, agrees to pass on the actual collections and actual variations in prices on the credit asset to the protection seller. Total Return Swap is also known as Total Rate of Return Swap (TRORS).
- Credit Linked Notes: It is a security with an embedded credit default swap allowing the issuer (protection buyer) to transfer a specific credit risk to credit investors. CLNs are created through a Special Purpose Vehicle (SPV), or trust, which is collateralized with securities. Investors buy securities from a trust that pays a fixed or floating coupon during the life of the note. At maturity, the investors receive par unless the referenced credit defaults or declares bankruptcy, in which case they receive an amount equal to the recovery rate. The trust enters into a default swap with a deal arranger. In case of default, the trust pays the dealer par minus the recovery rate in exchange for an annual fee which is passed on to the investors in the form of a higher yield on the notes.
- Credit Spread Options: A financial derivative contract that transfers credit risk from one party to another. A premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level. The buyer of credit spread put option hopes that credit spread will widen and credit spread call buyer hopes for narrowing of credit spread. It can be viewed as similar to that of credit default swaps but it hedges also against credit deterioration along with default. Consider the buyer of credit spread put: he/she pays a premium for the put. If the bond (the reference entity) deteriorates, the spread on the bond will increase and the buyer will profit. But if the bond quality increases, the credit spread will narrow, bond price will decrease, and the put will be worthless (i.e., put buyer has lost the premium). In summary, the credit spread put buyer wants to hedge against price deterioration and/or default risk of the obligation.