Credit Derivatives – Meaning and Definition

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. In case of corporates (bond issuers), credit risk occurs for the bond investors when the corporate fail to make interest payments on the bonds. Credit risk affects any party making or receiving a debt payment. Examples include bond issuers, bond investors and commercial banks. Bond issuers are affected by credit risk because their cost of borrowing depends upon their risk of default, these bond issuers are rated by credit rating agencies and these credit ratings reflect their credit quality. Investors in individual bonds are exposed to the risk of a decline in the bond’s credit rating. A downgrade in a credit rating will increase the bond’s credit risk premium and reduce the value of the bond. Banks are exposed to the risk that borrowers will default on their loans. The credit risk faced by banks is relatively high as compared to other risks faced by banks because banks tend to concentrate their loans geographically or in particular industries, which limits their ability to diversify credit risks across borrowers.

How to manage credit risk is the next question facing the banks today. Various methods are available to manage credit risk. Traditional methods have focused mainly on diversification. Over the past ten years, an alternative approach to managing credit risk has concentrated on selling assets with credit risk. Banks can sell their loans directly or they can securitize, pool together assets with credit risk and sell them to investors in parts. Unfortunately, the securitization approach is well suited only for loans that have uniform payment schedules and similar credit risk features, such as home mortgages and automobile loans. Loans for commercial and industrial purposes, in contrast, have diverse credit risks. In cases such as these, banks have to resort to other methods of controlling credit risk. Thus, credit derivatives emerged as new financial instruments to mitigate credit risk when it was impossible for loan sales or securitization to do so.

Meaning of Credit Derivatives

Credit derivatives, instruments that emerged around 1990’s, are a part of market for financial derivatives. Since credit derivatives are presently not traded on any of the exchanges, they are a part of Over-the-Counter (OTC) derivatives market. Credit derivatives are bilateral financial contracts that transfer credit risk from party to another counterparty without the ownership of underlying asset. Credit derivatives are off-balance sheet financial instruments that permit one party (beneficiary) to transfer credit risk of a reference asset, which it owns, to another party (guarantor) without actually selling the asset. It, therefore, “unbundles” credit risk from the credit instrument and trades it separately. The counterparty to derivative contract can either be a market participant or could be the capital market through the process of securitization. Possible features of this contract are the underlying (reference asset), the strike price, liquidity, maturity, default, credit event and protection payment.

Credit derivatives have several applications. Some of the uses of credit derivatives are that they help banks to reduce their credit exposure, facilitate trading of credit risk, help in the management of credit lines and they also increase liquidity of the market. Credit derivative product namely credit default swap can be very useful for the Indian corporate debt market. This product not only transfers credit risk but also acts as insurance against default. Credit default swaps have other advantages too. They enhance investment and borrowing opportunities and at the same time reduce transaction costs, hence, these products can prove extremely helpful in eliminating the deficiencies of corporate debt market and they have the potential to make corporate debt market more efficient.

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