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Credit Derivatives are over-the-counter (OTC) products that are used to mitigate credit risk exposure to a particular loan or a portfolio of loans. These contracts are primarily traded in the unregulated OTC derivatives markets (Futures Trading Practices Act of 1992 / FTPA). OTC transactions are primarily entered into, and traded by, institutional traders. Also, most dealers in the swaps market are either affiliated with broker-dealers or futures commission merchants that are regulated by the SEC or the CFTC, or are financial institutions that are subject to supervision by bank regulatory agencies.
Entering into a credit derivative contract requires that both parties monitor the "reference credit" to determine if a credit event has occurred and the Agreement has been triggered (as per the terms of the Agreement). In the event of a credit event, both counterparites to the Agreement must formally notify each respective legal, risk management, counterparty credit and credit administration departments with a Credit Event Notice. Ideally, the credit event will be defined under Article IV of the 2003 International Swaps & Derivatives Association’s (ISDA) Credit Derivatives Definitions. If both parties are in agreement that a credit event as per the terms of the Agreement has occurred, then a Trade Confirmation and Settlement Instructions need to be exchanged between counterparties.
The Credit Default Swaps (CDS) contract is designed to protect the purchaser against the risk of a bankruptcy, default,
non-payment, debt restructuring or other credit events.
Overall, the beneficiary of the swap (purchaser or protection buyer) makes periodic payments to the guarantor (seller or protection seller) in exchange for a guarantee against any loss that may occur if the asset defaults. The beneficiary transfers the credit risk of an asset it owns to the guarantor. The arrangement allows the guarantor to assume the credit risk associated with the asset without directly purchasing it (can also be used by the guarantor to diversify a portfolio if they are looking for exposure). The only risk is default risk and there is no price or spread risk in the contract (there is still non-credit related element of market risk or adverse changes such as asset values, interest rates, market volatility and market liquidity). Thus, In exchange for the “swap” payment, or premium, the beneficiary establishes the right to sell a specific reference obligation (the asset) issued by a reference entity (corporation, sovereign, etc.) to the guarantor at the par value, if a credit event occurs.
Pricing depends on:
The most active purchaseres of CDS are commercial banks (who tend to be holders of large corporate loan exposure), investment banks and hedge funds. The most active sellers of CDS are commercial banks, reinsurers / insurance companies, monoline insurers, investment banks and hedge funds. The CDS market has grown substantially (and globally) from its beginnings in the mid to late 1990s to, depending on who you ask, either USD$ 20 Trillion, USD$ 26 Trillion, USD$ 45 Trillion or USD$ 49 Trillion by the beginning of 2007. The greatest demand is still for single-name CDS however indexed CDS have also increased substantially, almost equal to single-name in volume.
ICE Trust, a limited purpose trust company, serves as a central clearing facility for credit default swaps (CDS). www.theice.com/ice_trust.jhtml
Total Rate of Return Swap (TRORS) are credit derivative that enables a lender to sell the cash stream of a loan but not the loan; are used by banks to reduce credit concentrations; the beneficiary may pay a total rate on an asset, including any appreciation in the asset's price, to a guarantor in exchange for a spread over funding costs plus any depreciation in the value of the asset. The beneficiary transfers the credit risk of an asset it owns to the guarantor. The arrangement allows the guarantor to assume the credit risk associated with the asset without directly purchasing it.
In a Spread-linked Swap, one party makes a periodic payment and pays or receives a final payment at maturity based on the spread of the reference security at maturity.
Credit Index Event Contracts are exchange traded (Chicago Mercantile Exchange / CME) credit default swaps. CME Credit Event Futures are triggered by the same events as standard OTC CDSs using ISDA conventions. Specifically, these contracts rely upon credit event definitions per Article IV of the 2003 ISDA Credit Derivatives Definitions, subject to confirmation from public sources, also per ISDA conventions. A “credit event” includes bankruptcy, obligation acceleration, obligation default, failure to pay, debt repudiation/moratorium, or restructuring.
Credit Event Futres trading schedules are during such hours and delivery in such months similar to other standardized
futures products. They require an initial performance bond deposit and are subsequently
marked-to-market (MTM) on a daily basis.
www.cme.com/trading/prd/ir/creditevent.html
After the CME product was introduced, Eurex launched its exchange-traded credit derivatives contract on 27 March 2007,
a future based on the iTraxx Europe 5-year index series (Eurex iTraxx Credit Futures), the
iTraxx Europe HiVol 5-year Index Futures and the iTraxx Europe Crossover 5-year Index Futures.
iTraxx Europe 5-year Index series http://www.eurexchange.com/trading/products/CRD/F5E0_en.html
iTraxx Europe HiVol 5-year Index series http://www.eurexchange.com/trading/products/CRD/F5H0_en.html
iTraxx Europe Crossover 5-year Index series http://www.eurexchange.com/trading/products/CRD/F5C0_en.html
On Tuesday, June 19, 2007 Chicago Board Options Exchange (CBOE) launched Single-Name Credit Event Binary Options (CEBO)
on individual companies. These products are also known as Credit Default Options. The CBOE indicates that it plans to
also launch Basket CEBOs (Credit Default Basket Options).
www.cboe.com/micro/credit/introduction.aspx
The Chicago Board of Trade (CBOT) offers CDR Liquid 50 NAIG Index futures based on the CDR Liquid 50TM North American Investment Grade Index (NAIG) Index.
Default Notes are structured notes linked to the credit risk of an entity (reference credit) and the note's redemption are usually linked to a particular instrument of the entity although it is not necessary. Default notes are synthetic bonds although their risk profile can be substantially different from the profile of the credit instruments issued by the entity.
Spread-Linked Notes are structured notes linked to the credit spread risk of a credit instrument at maturity of the credit derivative structure. Spread-linked notes are synthetic bonds with a maturity different from those of the underlying instruments, often with some leverage.
Levered Notes are structured notes linked to the performance of an underlying credit instrument. The leverage results in a higher yield to maturity than the underlying instruments, although it comes at a higher risk.
Credit-Linked Notes (CLN) are issued by a special purpose company or trust and combines a credit-default swap with a regular debt instrument / note (with coupon, maturity, redemption). the investor in the note also assumes all or a portion of the credit event risk.
Default Options are a type of put option on price with pay off contingent on default or an extreme credit deterioration event. The risk of the options are limited to the premium paid. The pricing of a default option depends on maturity, current spread, and definition of default event.
