Financial and credit derivatives: concepts and applications

Credit Derivative (CD) is a contract (derivative security) to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. This is usually achieved by transferring risk on a credit reference asset. Early forms of credit derivatives were financial guarantees. Recent credit failures, such as Enron, Worldcom and Parmalat, have given CDs a bad name, and bankers who think that credit derivatives give them risk protection may find themselves on the wrong end of market mispricing. "So many bankers are relatively unperturbed by the charges that firstly, CDs are mispriced and secondly, they represent much less of a revolution in financial markets than previously believed. But they could be knocked out of their complacency if the market continues to grow, bringing within its grasp a much wider range of credits and risks."

The idea of credit derivatives is to avoid direct ownership of the securities referenced in the transaction. This is achieved, as elsewhere in financial markets, by the use of a reference rate and other reference concepts such as reference entity (also known as reference credit), that is, a specified legal entity, which may be a sovereign, financial institution, corporation, or one of a number of specified entities. A reference asset is a generic term for any holding, obligation, debt or other form of credit instrument that is "referenced" in the transaction reference security is usually, a public security issued by the reference entity, but also a reference asset or reference obligation such as a loan or other financial asset. A credit event is an event defined within the credit derivatives contract, that happens in respect of the reference entity. It is usually defined in the Master Agreement of a credit derivatives contract. The three credit events under ISDA (2003) definitions are bankruptcy, failure to pay, and restructuring.

Some common forms of credit derivatives are total return swap, credit default swap and credit linked note. Total return swap, or total rate of return swap (TRORS), is a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness of the reference asset, especially where the payments are based on the same notional amount. The reference asset may be any asset, index, or basket of assets.

The TRORS allows one party to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other, which does retain that asset on its balance sheet, to buy protection against loss in its value. The essential difference between a TRORS and a credit default swap (CDS) is that the latter provides protection not against loss in asset value but against specific credit events. In a sense, a TRORS is not a credit derivative at all, in the sense that a CDS is. A TRORS is funding-cost arbitrage. Typical users would be hedge funds in the market to seek protection against asset value loss, in order to take advantage of leverage.

The credit default swap is the most widely used credit derivative. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity. A CDS is often used like an insurance policy, or hedge for the holder of a corporate bond. The typical term of a CDS contract is five years, although in the case of an over the counter derivative almost any maturity is possible.

CDS contract typically includes a reference entity, which is the company who has issued some debt in the form of a reference obligation, usually a corporate bond. The period over which default protection extends is defined by the contract effective date and termination date. The contract nominates a calculation agent whose role is to determine when a credit event has occurred and also the amount of the payment that will be made in such an event. Another clause in a CDS contract is the restructuring, which determines what restructuring of the reference entity's debt will trigger a credit event. For example, a company that is experiencing financial trouble may decide to extend the maturity of its bonds and therefore defer its payments. Depending on the restructuring specified in a CDS this may or may not trigger a credit event. Generally a contract that is more lax in its criteria for default is more risky and therefore more expensive. Another factor that affects the quote on a CDS contract is the debt seniority of the reference obligation. In the event of a company becoming bankrupt bonds that are issued as senior debt are more likely to be paid back than bonds issued as subordinated, or junior debt, hence junior debt trades at a greater credit spread than senior debt.

Sellers of CDS contracts will give a par quote for a given reference entity, seniority, maturity and restructuring e.g. A seller of CDS contracts may quote the premium on a five-year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. The par premium is calculated so that the contract has zero present value on the effective date. This is because the expected value of protection payments is exactly equal and opposite to the expected value of the protection payments. The most important factor affecting the cost of protection provided by a CDS is the credit rating of the reference obligation. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher.