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Understanding the Different Kinds of Credit Derivatives

By: , dated January 25th, 2013

Derivative. Credit. Swap. These terms are heard in the news and are on the lips of investment bankers as they dine in fancy restaurants off of Wall Street, but the complexity of these financial instruments can unnerve most investors who generally focus on stocks, bonds, mutual funds and ETFs. While not part of the daily financial lives of most people, credit derivatives (CDs) undoubtedly influence the value of our investments and can cause the stock market to rise or a company to falter.

In the most basic of terms, a credit derivative is a financial tool used to shift risk from one party to another. They are a relatively new addition to the financial toolbox of investment bankers, having popped up in the 1990s. By allowing the mitigation of risk by spreading it out over a number of investors, companies and banks are able to see increased profits since they are no longer alone when it comes to facing the risk of a credit event (e.g. bankruptcy, insolvency) or a loan.

For example, a bank that sells a loan to an automotive plant is worried that the plant may not be able to pay all of its debts. The bank can sell the risk associated with the debt to investors, but still keep the loan to the automotive plant on its books. The value of the derivative is “derived” from the value of the bond held by the bank. The credit derivative allows these investors to invest in the risks of a firm (the bank) without actually having to purchase that firm’s bonds or loans. The higher the risk of a credit event occurring, the higher the price of the credit derivative.

There are several types of derivatives. Three basic forms are:

Credit Default Swaps

A credit default swap is a swap wherein the counterparty receives a premium at predetermined periods in consideration for assurance to make a specific payment if a negative credit event occurs. Credit events are described as bankruptcies, debt restructurings, obligation defaults or failures to pay. Consequently, the swap is annulled once the credit event takes place. Usually, the amount of the payment is associated with the reduction of the market value of the asset after the credit event. Credit default swaps are customized to diversify or hedge credit portfolios.

Total Return Swaps

With a total return swap, two parties enter into an agreement in which one party agrees to receive the total returns (interest payments and capital gains or losses) of an asset, while the other party receives interest on a notional amount. The asset referenced in the swap deal can be any asset, index or a basket of assets. Total return swaps are utilized to transfer credit risks between two parties.

Credit Linked Note

The value of a credit linked note depends on the occurrence of a credit event, such as a bankruptcy. They are an embedded credit default swap in which investors accept exposure to a particular credit event in return for a higher yield on the note. As opposed to credit default swaps, credit linked notes are logged on a balance sheet as an asset. The most fundamental credit linked note includes a bond, issued by a high-rated borrower, along with a credit default swap on a less creditworthy risk. Credit-linked notes are normally issued by dealers or by special-purpose companies (or special-purpose vehicles, SPVs) residing in an offshore location and are collateralized with securities having the highest credit rating of AAA. SPVs are set up by dealers to issue various credit linked notes. The coupon or price of the note is linked to the performance of an asset. If there is no default, the credit default swap expires, the collateral redeems at maturity, and the collateral redemption proceeds are paid back to the investor. However, if a credit event occurs, the collateral is sold and its proceeds are used to pay the dealer the par amount. The dealer either pays the investor the recovery amount, in the case of a cash settlement, or delivers obligations to the investor in case of physical settlement

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