Credit derivative

A Credit Derivative is a contract 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 derivative were financial guarantees. Some common forms of credit derivatives are

• Total return swap
• Credit default swap
• Credit linked note.

Key concepts of the credit derivatives market

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 (aka reference credit) A specified legal entity, which may be a sovereign, financial institution, corporation, or one of a number of specified entities.
• Reference Asset - a generic term for any holding, obligation, debt or other form of credit instrument that is "referenced" in the transaction
• Reference Security. 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.
• Credit Event. 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. For example, the six credit events under ISDA (1999) definitions are Bankruptcy, Obligation Acceleration, Obligation Default, Failure to Pay, Repudiation/Moratorium, Restructuring.

Note that, as a result of a recent confusion about what constitutes certain credit events, the ISDA agreement has recently changed.

Total return swap

A total return swap (a.k.a. Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets.

The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset.

The essential difference between a TRS and a Credit default swap (qv) is that the credit default swap provides protection against specific credit events. The total return swap protects the against loss of value irrespective of cause, whether default, widening of credit spreads or anything else.

Credit default swap

The Credit default swap or CDS has become the main engine of the credit derivatives market, offering liquid price discovery and trading on which the rest of the market is based. 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 happening in the reference entity. The contingent payment is usually represents the loss incurred by creditors of the reference entity in the event of its default. It covers only the credit risk embedded in the asset, risks arising from other factors such as interest rate movements remaining with the buyer.

Pricing a CDS

It is relatively easy to get an approximate price for a credit default swap, using arbitrage arguments. Compare (a) the return achieved by one who pays £100 for a risky bond B maturing at time T and (b) the return achieved by one who invests £100 at the risk free rate, until time T, and simultaneously sells protection via a CDS on bond B.

Clearly both positions have a similar risk, which is of bond B going into default. In case (a) the investor gets only the recovery rate attached to B (the amount given a creditor of this type can recover on liquidation), in case (b) the seller of the CDS must purchase bond B for its face value, £100, which entails liquidating the risk free investment, and selling B at its recovery value. Arbitrage arguments suggests that similar risks should be compensated by a similar excess return. Thus the premium paid to the seller of the CDS should be approximately equal to the difference between the coupon of B, and the risk free rate.

To facilitate pricing, premium on a CDS is paid at a similar frequency to that in the swap and bond markets (typically quarterly).

The pricing method is approximate in that it ignores the credit risk of the CDS seller, who may be unable to buy the bond in the event of default (suppose in an extreme case that the seller is also the issuer of the bond which is protected).

Credit Linked Note

(To follow)