In recent years, the impressive growth of the
credit derivatives market has attracted much attention.
Credit Derivatives are privately held transferable bilateral contracts
that let users manage their exposure to the possibility of a credit
risk. Credit derivatives are very much similar to forward contracts,
swaps, and options for which the price is driven by the credit risk
of private investors or governments.
|
| Types of credit derivatives: |
| The credit derivatives being
presently used in the market can be widely classified into the following: |
- " Total return swap:
Total return swap is a swap or exchange of the aggregate return
out of a credit asset in contrast to a contracted prefixed return.
Here the protection buyer expects a guaranteed prefixed return
from the protection seller. In turn, the protection buyer accepts
to transfer the all the benefits of the credit assets to the
protection seller. The protection buyer exchanges the total
return from a credit asset for a decided prefixed return. The
total return out of a credit asset can be influenced by various
elements, some of which may be quite irrelevant to the asset
in question, like driving interest rate, wavering or fluctuations
of exchange rate etc.
- " Credit default swap:
Credit Default Swap is an agreement in which one party transfers
third party credit risk to another party. Party (the buyer)
in the swap is a lender and faces credit risks from a third
parties (Issuers), in which case the counterparty (Insurer or
CDS provider) in the credit default swap agrees to insure this
risk in exchange for regular periodic payments.
- " Credit linked notes:
Under this, notes are issued by the protection buyer. The investor
who buys the notes has to permit either the deference or delay
in repayment or has to foreit interest, if any defined credit
event, say, default or bankruptcy, takes place.
- " Credit Spread Option:
Credit spread option is the difference between the yield on
the debt securities of a particular corporate and the yield
of similar maturity treasury debt services. Credit spread options
are framed to hedge against the changes in credit spreads.
|
| The need and advantages of credit derivatives: |
- 1. The absence of a tailor-made risk management product highlighted
the need of a credit derivatives market. It is to meet this
need that it came about.
- 2. Without a credit derivatives market, it becomes difficult
to keep apart the management of credit risk from the asset with
which the risk is linked.
- 3. Credit derivatives are the first method in which short
sales of credit instruments can be rendered with moderate liquidity.
Short positions can be achieved synthetically by purchasing
credit protection using a credit derivative
- 4. Credit derivatives, excluding those implanted in structured
notes, are off-balance sheet instruments. The appeal of off-balance
sheet assets however will differ from institution to institution.
- 5. The more costly the balance sheet, the higher the appeal
of an off-balance-sheet option.
|
| Risk associated with Credit Derivatives: |
Credit derivative
transactions are negotiated over the counter and thus include huge
degrees of counterparty risk. Failed or delayed payments by sellers
of protection could permit the buyers unprotected to unforeseen
credit risk on loans and bonds. The same difficulty is also accompanied
with the issue of eagerness to pay. The most distinct problem includes
issues relating to legal and documentation risks. The market participants
and legal experts have raised doubts as to the capability of a protection
buyer to implement payment following a detailed default event.
|
| The growth of the global Credit Derivatives
Market |
 |
| Source: British Bankers' Association
- Credit Derivatives Report 2006 |
|
Year |
Size (in
USD billion) |
1996 |
180 |
1998 |
350 |
1999 |
586 |
2000 |
893 |
2001 |
1189 |
2002 |
1952 |
2003 |
3548 |
2004 |
5021 |
2006 |
20207 |
2008(est.) |
33120 |
|
The growth of the global credit derivatives market has excelled
the expectations from the 2004 BBA survey which predicted a market
size $8.2 trillion by 2006. This year's survey estimates that by
the end of 2006 the size of the market will be $20 trillion. Banks
this year now consider that at the end of 2008 the global credit
derivatives market will have expanded to $33 trillion. This growth
is expected to continue. It is not just the size of the market that
has continued to grow but also the diversity of products.
|
| Why Companies use credit derivatives? |
| Firm |
Buying Protection For: |
Selling Protection
for: |
| Bank |
Credit
risk Management, withhold possession of loans and profit,
regulatory capital relief. |
Industry
diversification of loan portfolio, compensate cost of hedging
other credits. |
| Insurance
Company |
Reduce
or diversify the liability concentrations on insurance portfolio
without having to sell bond positions. |
Increase
diversification, improve yield, and match maturity profile
of liabilities. |
| Securities
Dealer |
Market
intermediary, credit risk management, regulatory capital relief. |
Market
intermediary, Industry diversification of loan portfolio,
compensates cost of hedging other credits. |
| Asset
Manager |
Negative
looks of a credit, strategic trade construction, put on forward
trades. |
Express
positive views on a credit (yield improvement and diversification
growth). |
| Hedge
Fund |
Convey
negative views on a credit, package with convertible bonds,
put on forward or long positions. |
Express
positive views on a credit (can be cheaper than bonds and
provide elemental leverage). Put on forward or long positions. |
|
| Conclusion: |
Credit derivatives
have many purposes and furnish flexibility to transfer and price
credit risk more comfortably. The market has been progressing throughout
the world as in estimated to soon cross $100 billion. The anticipated
defaults in the Asian markets are expected to add to this growing
market. Credit derivatives are likely to be used more adequately
in those situations where buying or selling in cash markets is clumsy
and less accomplished. |
| |
| |
