Financial Derivative the Aim of Term Paper

  • Length: 8 pages
  • Subject: Economics
  • Type: Term Paper
  • Paper: #60776383

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The developments of credit derivatives began in 1980s as a new financial innovation after the swap market started. Swap market provided derivative organizations with profit due to their intermediary position while the credit margins for borrowers were reduced. As the swap market developed there was the development of new interest derivatives so that there were additions to the list of products. Credit derivatives are relatively recent introductions and these are mechanisms for the credit institutions to separate the credit risk from their loans and treat market risk as a separate category so that their pricing efficiency could be more competitive and the concerned organizations could be more competitive in the market. (Credit Derivatives Move Beyond Plain Vanilla)

Thus one can say that credit derivatives are a recent form that can be used by bankers to reduce risk, or increase risks and thus meet their corporate objectives. The general form of credit derivatives is a bilateral contract and the aim of that contract is to reduce their exposure to credit risk. For a bank like ours, the feeling may be that one particular customer is in difficulty and may not be in a position to repay the loan that has been given to him, or has been renewed for him. The bank can seek protection through selling the concerned credit risk to another party, though the risk will still remain on its books. It is not only for loans that the procedure may be used, but for any debt instrument or a group of instruments. While going through the procedure, one of the side results is the establishment of a default price for the loan or instrument. Apart from the reduction of risk, other organizations which have not made the loan can gain benefits from the loan that they have not made directly. (Credit Derivatives Move Beyond Plain Vanilla)

In a way the instrument offers a flexible method of managing risks of credit and also to improve yields from credits synthetically. This is due to the ability that it gives methods to purchase synthetic credit. At the same time, it cannot remove all risks in giving credits as though it may not have given direct credit to a company which is in a little difficult position, it may have got into a derivative for that company. There are also other instruments like Special Purpose Corporations/Vehicles that can be created to avoid the risks of getting into derivatives of companies with a little risky situation. This leads to different forms of credit derivatives - Credit Linked Notes, Total return Swaps, Credit Default Puts, Credit Spread Options and other forms. The concerned definition of credit risk in all these discussions is the likelihood of the borrower failing to service or repay a debt in time. The market notes this deficiency through the user of the credit rating for the party, and this is what defines the premium that it pays over the market price for its debts.

Thus the risk involved in giving a loan to a party has two elements - market risk and firm-specific risk. The benefit of credit derivatives is that it is allowing the lender to separate the risks that are involved and then insuring itself by selling those risks to others who are in the best position to evaluate and manage those risks. Earlier the methods of controlling them were through refusals to make loans, taking out insurances, through guarantees and letters of credit, etc. These were useful in normal situations, but when the market itself moved into a difficult situation due to economic downturns, and then all parties were likely to default at the same time. Thus financial institutions felt that they needed more security and came out with this scheme. (Credit Derivatives Move Beyond Plain Vanilla)

Now the credit derivatives market has grown and is expected to be near the $1 trillion mark, and this is causing demands for the systems to be calculated easily. This is leading to requirement of technology and other support for the trade and management of credit instruments. Leading organizations dealing in this area have already asked their software suppliers to develop applications which will support their business. (Designed for dealing) Earlier the use of these instruments were limited to banks, but now among the users are a large number of insurance companies, hedge funds, mutual funds, pension funds, corporate treasuries and even direct investors who are trying to get their yields increased or transfer the credit risks which they are now incurring. Earlier the credit derivatives were only for the use of financial institutions to manage their concentration of credit instruments and liabilities and now they are finding even to use credit exposure through support from others.

There are now many types of credit derivatives that are being used, but for our purpose we shall concentrate on four major varieties that make up the biggest volumes in them. These are Total return swaps, Credit default swaps, Credit spread options and Credit linked notes. They are often also named slightly differently and this makes it very difficult to have constant terminology for this market. Credit default swaps are also called credit swaps by some users. This is what makes the traders and marketing personnel use the complete descriptions of profile of transactions that each deal contains. The first item being discussed is a total return swap and that permits the investor to receive the total returns from the concerned asset, but the investor does not buy the asset. The return means the income from the asset less or increased by any changes in capital value that occurs during the period the deal is for. Thus one of the parties to the deal pays the total economic return for a notional amount of principal that the deal is for. In return, the other party pays the regular fixed or floating rate of interest and some difference. The reference rates of interest can be any other financial asset, or basket of assets or even an index. The changes on using this derivative can be in using one asset, or even a single credit made by the party. The reference levels have minimum and maximum levels fixed on some reference credit that is fixed earlier. The life or these agreements is for periods from one year to three years. This method is used by banks to transfer the risks of credit that they have given out to another party. (Credit Derivatives Move Beyond Plain Vanilla)

Another instrument is called credit default swap and this is also used for distribution of the default risk of securities, and improvement of risk management by lenders and investors. In this case one of the parties has to make periodic basis points payments while the other party has to make payments for the principal if the borrower does not pay the money back in time. The costs of this instrument is fixed on the quality of the reference credit, supply and demand situation of the reference credit and the spreads that are available in the market at the time the deal is made. When we have made a loan to a party and do not want to make the loan then we can buy a credit default swap without even informing the party and this does not require the parties consent which would have been required if the loan was sold to another party. This may be used by us even for a basket of loans. Another item is called credit spread options and this can be bought or sold. This provides an opportunity to find out the position on future credit risk of the party. This permits the fixing of present spreads or even gets a premium if the spread moves in the opposite direction.

One can even buy securities at low prices on a forward basis. Generally these are used in a manner similar to bonds which have a benchmark of comparable maturity. Thus a bank may buy from an investor an option on the credit spread of a BBB-rated corporate bond which has a maturity after 5 years. For this a premium will have to be paid. At the same time, the bank will have the right to sell the bond to the investor at a certain strike price. This strike price is in terms of a difference with treasury notes, and if the actual spread on the date of maturity of the deal, is more than the strike rate specified, then the option will not be used. If the actual difference is higher, then the bond may be purchased. (Credit Derivatives Move Beyond Plain Vanilla) All these are methods to increase earnings from money or the availability of money. Another area is the Credit-linked notes and this is also growing very fat in the market of credit derivatives. The method of issuing this is against the performance of some existing reference asset. This offers any investor an opportunity for buying a credit…

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