Credit Derivative: An Introduction

Abstract

Almost all of the financial instrument are inherent with credit risk, which is exposed if the borrower is unable to meet the financial obligation on time. To minimize such credit risk financial institution go thoroughly to the credit worthiness of the borrower, which is a traditional way to minimize the potential risk by avoiding it. The modern evolution of financial market have developed sophisticated instrument and techniques to minimize credit risk. One of them is credit derivative, these instrument helps to segregate the credit risk from the underlying assets and makes the credit risk tradeable. The first part of the article is focused on the introduction, development and advantage of credit derivative. The second part analyze the various types of credit derivative instrument as modern technique for managing potential credit risk. Finally some of the risk associated with the credit derivative instrument have been analyzed on the third part to give the basic outlook on the various instrument of sophisticated credit risk management instrument of advance Derivative and Commodities market.

Keyword: Credit Risk, Credit Derivative, Credit Default Swap, Total Return Swap, Assets Swap, Credit Linked Note

Introduction

Credit Derivative indicates the instrument or technique that helps to separate and transfer one of the major risk of traditional finance; that is credit risk. Credit risk is associated with the obligation, it arises when the pre-determined obligation with financial instrument is not fulfilled on time. This indicates the counter party default on promised obligation. Derivative products or Instrument created on this credit risk is credit derivative product, they were first purposed in 1992 at Conference of International Swap and Derivative Association (ISAD). A credit derivative consist privately held negotiable contract that allows users to manage their exposure to credit risk related to an underlying entity from one party to another without the actual transference of underlying entity. Credit derivative also enables stripping the credit risk of a security from its other risk. Credit derivative are the over the counter (OTC) product and hence can be tailored to the user specification.

Application and Advantage of Credit Derivative Products

As mentioned in the introduction part that the credit derivative is mainly used to segregate and minimize the credit risk. This enables the lenders or the investor to take the credit risk as per their capacity and it also can be applied in various places. The application and advantage of credit derivative will try to explain such ground for the usage of credit derivative products and their advantage. Credit derivative decompose and strip the credit risk from the securities which enables the credit risk to be managed independently of other risk they also can be tailored to the specification required of the buyer of credit protection which makes the credit derivative product complex as well as sophisticated.

Basically, credit derivative are used for hedging the credit risk; this includes credit default risk, dynamic credit risk and changes in credit quality. In the broad sense, they are treated as the financial shock absorber of the economy and hence helps to create macroeconomic and financial stability.

The unfunded credit derivative product (which will be discussed later) are the off balance item. The off-balance sheet items are not shown in the balance sheet of the company, so that they enjoy higher flexibility and leverage like other financial derivative. The other advantage is from the point of buyer of credit derivative is that the credit derivative allows investor to access new assets class (example: syndicate loan). Earlier this type of loan was only accessible by limited market participant. The higher leverage built in credit derivative market makes it more attractive to take the exposure via a credit derivative than that of cash instrument.

In the daily life, the commercial bank, the saving and loan association, finance companies, etc. can use credit derivative to hedge their credit risk on the loan that they have provided. The credit derivative transfer the risk in specific loan to third parties, which is called hedging of risk. This is done by creating synthetic short position by the use of credit derivative. The bank can also take new exposure by creating synthetic long position on loan or other instrument with the help of credit derivative product. This kind of activities would have been impossible without the existence of credit derivative product. Also, short position can be taken with credit derivative without risk of liquidity or delivery squeeze as it is a specific credit risk which is being traded. This can be generalized with the example that, it is not possible to trade ‘short sell’ a bank loan in cash market but a credit derivative product can be used to establish synthetically the economic effect of such position.

Last but not the least advantage of credit derivative instrument is that it enables the creation of synthetic instrument of any desire maturity. For example: a seller of protection of credit derivative can take three years of credit exposure to a given entity even though if there is no three years credit issued by the counterparty.

Funded and Unfunded Contract

Credit derivative products are classified into funded and unfunded instruments. In the funded contract, the insurance protection payment is made to the buyer of contract at the beginning. If the credit event of risk occurs before the maturity of the contract, the buyer of the contract is compensated by the insurance protection amount made at the beginning of the transaction. If no such event occurs, the payment is returned to the protection seller. On the other hand in the unfunded contract the protection payment is made if the event of risk occurs, before the maturity of the contract. That means, the protection seller do not have to make an upfront payment of the protection to the buyer of the contract at the beginning of the transaction. Moreover, if no such credit event of risk occur before the maturity, no payment have to be made at all. This indicates that the unfunded credit derivative instrument are more flexible in terms of execution. However, a buyer of contract prefers to have funded credit derivative instrument rather than unfunded ones. Credit Linked Noted (CNS) is a funded credit derivative instrument whereas Credit Default Swap (CDS) is an example of unfunded credit derivative instrument.

Types of Credit Derivative Products

1.      Credit Default Swap: Credit Default Swap (CDS) is the most common and most important instrument of the credit derivative market. It is often called as credit swap or default swap. According to Choudhry (2013), A CDS is a bilateral contract in which the protection buyer pays the periodic fixed payment or one off premium to protection seller, in exchange the seller will make the single contingent payment on the occurrence of specified credit event associated with the underlying assets. The CDS enables one party, the buyer of protection to transfer their credit risk with another party, the seller of protection.

In the words of Sundaram & Das, (2013) the credit event can occur in the form like failure to pay, bankruptcy, obligation default, obligation acceleration, repudiation/moratorium etc. The soft credit event like restructuring, which includes reduction or postponement of interest or principal repayment are also taken as credit event in CDS. From the investor point of view this can be explain in simple way that an investor purchase a protection against the above mention credit event and pays premium to the counterparty which is very much similar to buying an insurance policy and paying insurance premium to the insurance company. The term ‘going long’ on CDS indicates buying protection and paying premium and vice versa.

The maturity of CDS doesn’t necessarily need to be the same as of the maturity of underlying assets. For example: An investor purchases a corporate bond of 10 years maturity. Since, the bond is not free from credit risk, the investor also purchases CDS against the credit risk associated with the corporate bond and the maturity of this CDS doesn’t necessarily be of 10 years tenure.

Finally, the settlement of CDS can be either physical settlement or cash settlement. The process of physical settlement includes protection buyer delivers the defaulted obligation to the protection seller and receives the par value of the obligation in exchange. Where as in cash settlement the protection seller makes a cash payment to protection buyer equal to the loss amount in credit event.

The two major types of CDS includes Basket Default Swap and Credit Default Exchange Swap. If there are more than one reference item in a basket, the protection taken against more than one item or specified item in the basket is Basket Default Swap. The specified item can be expressed in terms like first-to-default, second-to-default, nth item to default (out of z item) or last zth item to default. In Credit Default Exchange Swap two industries of different region or industries can diversify their loan portfolio in a single non funded transaction by hedging the concentrate risk of the loan portfolio. This is more in practice in commercial bank to swap the risk of their loan portfolio.

2.      Total Return Swap: Total Return Swap (TRS) or total rate of return swap is also a bilateral contract that exchange the total return from a financial assets between them. According to Francis et al. (1999) A TRS is a swap agreement in which the total return of bank loan or credit sensitive security is exchanged for some other loan or credit sensitive security. For the better understanding of TRS the party paying the total return of an assets is called total return payer, the counterparty receiving the return is called total return receiver and the specified assets is called reference obligation. TRS was popular in early days of credit derivative market. It is one of the principal instrument for the BFI to manage credit risk.

Total return swap not only swap the cash flow from the interest and coupon payment but also swap the value of capital appreciation of the underlying reference obligation. However, there can exist the situation of capital depreciation implying the negative value of TRS. In this situation the total return receiver makes the payment to total return payer.

The advantage of TRS is that it enables access to desired assets class such as syndicate loan, without TRS this was not possible (Sundaram & Das, 2013). It also enables new assets with various maturities that are not available in the market. That means investors can gain efficient off balance sheet exposure to desired assets class to which they otherwise wouldn’t have access in it. Also, investors can reduce administrative cost through an off balance sheet purchases. The long term investor, who feels that the reference assets in the portfolio may widen in spread in the short term but thinks that will recover later can entered into the TRS of shorter than the maturity period of the assets. This structure is flexible and doesn’t require the sale of the assets, which is beneficial for the payer of TRS.

3. Assets Swap: In the words of Choudhry (2013), the Assets Swap is the combination of and interest rate swap and bond which is used to alter the cash flow profile of the bond. They are used to transform the cash flow characteristics of bond either by fixed coupon rate bond to floating rate bond or vice-versa. In the Assets swap the bond coupon is swapped on LIBOR plus spread. LIBOR stands for London Interbank Offer Rate, which indicates the benchmark rate that some of the world's leading bank charge each other for short term loan, it serves as the initial step to calculate interest rate on various loan throughout the globe. Assets swap can be used to transform the cash flow characteristics of reference assets, such as bond; so that the investor can hedge currency, credit and interest rate risk to create synthetic investment with more suitable cash flow characteristics (Pereira, 2003). Assets swaps are used to fulfill a variety of goals but are generally undertaken to transform the character of an investor's assets. For example a bank may use an assets swap to convert long term fixed rate assets to floating rate assets to floating rate assets to match their depositors' account, which represent short term account liabilities (fincad.com).

      The buyer of the assets swap takes the credit risk of the bond. That means, if bond defaults, the swap buyer have to pay the interest of the bond which cannot be compensate from the underlying bond or on the other hand the swap can be close-out at the market value. The assets swap buyer is exposed to the loss of the coupon and redemption on the bond. The loss on the redemption of bond occurs by the difference of the bond price and recovery value (O'Kane, 2000). The assets swap buyer takes the benefit of assets swap from the assets swap spread, which occur as the value for the buyer for taking the above mention risks. The other advantage of the asset swap is to enable an investor to take exposure to the credit quality of the underlying assets with nominal interest rate risk and to take advantage of mispricing in floating rate market.

      There are several variations of asset swap available in the market, however, par asset swap and cross currency asset swap are widely used asset swap.

4. Credit Linked Notes: Credit Linked Notes (CLNs) is one of the unfunded off balance sheet instrument which transfer the credit risk of the issuer to the investor through the issue and redemption of underlying securities. Since, CLNs is an unfunded credit derivative instrument there is no upfront payment to purchase a CDS. CLNs represent one method by which CDS are covered into funded form. In other words it is effectively a fixed interest instrument with CDS embedded in it. CLNs are used by the commercial bank to manage both their credit risk exposure and balance sheet.

      The upfront payment of the note is done by the buyer of CLNs. The coupon and principal repayment of the note is tied up with the reference obligation, since the contract is based on reference obligation which can be one single instrument, number of instruments or market index as mentioned in the contract. If no credit event occur with the reference obligation then the coupon and principal payment will be done accordingly however, if the reference obligation experience credit event then the loss in the value of reference obligation is taken out of the note and the balance is returned to the investor (Sundaram & Das, 2013). From the perspective of issuer of CLNs it helps them to rise capital while protecting themselves against the failure of counterparty. The investor benefits from enhanced yield for the acceptance of additional risk but they are exposed to counterparty risk of reference obligation and the issuer. The investors also can diversify their portfolio through CLNs through two ways. First, with the help of new assets class; second, with the access of new counterparty.

      CLNs can be altered as per the requirement of the issuer. The most common variation of the CLNs is the Special Purpose Vehicle (or Special Purpose Entity) denoted by SPV or SPE, however they are more complex in nature. Also, the basic CLNs can be altered by incorporating some of the features of TRS and other security.

5. The other type of credit derivative instruments are;

·         Credit Spread Option (CSO)

·         CDS Index Products (CDSI)

·         Constant Proportion Debt Obligation (CPDO)

·         Collateralized Debt Obligation (CDO)

Risk inherent in Credit Derivative

      Counterparty risk is taken by each party in any or the OTC derivative, hence it is present in all class of financial assets including equity derivative, forex, commodities and credit derivative. So, one of the major type of risk associated in credit derivative instrument is the counterparty risk. It is one of the sub class of credit risk and occurs while the loan has default risk. The conditions for counterparty risk in Credit Default Swap can be either of default of reference entity or counterparty or both. The legal risk in credit derivative arises from the ambiguity regarding the definition of default. This indicates that certain thing can be termed as default in a jurisprudence whereas may not be another jurisprudence. Also, legal provision may not define some situation, since new credit derivative instruments continuously emerging. The regulators' of the credit derivative may have limited scope to regulate these instruments, eventually creating regulatory risk. The other type of risk are liquidity risk generally occur in thin market however the market should be adequately liquid for the existence of credit derivative and model risk which indicate the probabilities of default are hard to estimate. Also, it may not always channel risk to those who best handle/understand it. Finally, there are always new innovative instrument keep appearing in this field which are not adequately tested by the market and can create unseen risk.

Conclusion

      Credit Derivative Instrument exist in the advance capital market, where the various dimension of the market have been adequately developed. They are the innovative instruments which helps to minimize the credit risk associated with various financial instrument. However, they are not able to mitigate the risk completely. Availability of these instrument helps the market to access new assets class and help to diversify the investors' portfolio. With no doubt, there are various pro and cons of the credit derivative, the investor should be aware of the use and application of the instruments. They should be able to measure and manage the counterparty risk, correlation and liquidity. From the regulatory prospective, credit derivative open the new horizon for market regulation, legal provisions, capital adequacy requirement regime etc. on the other hand the regulators need to ensure that the financial intermediary have the proper risk management technique, which includes advance system, software, alert generation mechanism, expertise, control mechanism in place for the credit derivative operation.

References

1.      Bomfin, A. (2003), "Understanding Credit Derivatives" Elsevier Academic Press, London, UK

2.      Choudhry, M. (2013), "An Introduction to Credit Derivative" 2nd Ed. Butterworth Heinemann, Oxford, UK

3.      Francis, J., Frost, J., & Whittaker, J., (1999) "The Handbook of Credit Derivative" McGraw Hill, New York

4.      http://www.fincad.com/resources/resource-library/article/valuing-asset-swaps-and-asset-swap-spreads

5.      http://treasurytoday.com/2004/03/credit-derivatives-credit-linked-notes

6.      Pereira, R. (2003), "Understanding Assets Swap" An working note on yieldcurve.com http://www.yieldcurve.com/Mktresearch/LearningCurve/LearningCurve4.pdf

7.      O'Kane, D. (2000), "Introduction to Asset Swaps" Analytical Research Series, January 2000 Issue, Lehman Brothers International (Europe)

8.      Schöpf, W. (2010), "Credit Default Swap Trading Strategy" Diplomic Verlag, Hamburg, Germany

9.      Sundaram, R. & Das, S. (2013), "Derivatives: Principles and Practice" McGraw Hill Education (India) P. Ltd. New Delhi

10.  Weithers, T. (2007). Credit Derivative, Macro Risks and Systematic Risks, Economic Review, Federal Reserve Bank of Atlanta, 4th Quarter 2007, 43-69

Ajaya Dhungana

Officer, Securities Board of Nepal

(Published in SEBON's 26th year article collection book)