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Credit Derivatives.pptx.........................
- 2. • A credit derivative consists of privately held negotiable bilateral contracts that allow users to handle their exposure to credit risk. Credit derivatives are financial assets such as forward contracts, swaps and options for which the price is driven by the credit risk of economic agents, such as private investors or governments.
- 3. UNDERSTANDING CREDIT DERIVATIVES • Credit derivatives transfer credit risk related to an underlying entity from one party to another without transferring the actual underlying entity. • For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.
- 4. UNDERSTANDING CREDIT DERIVATIVES • There are many different types of financial instruments in the marketplace. Derivatives stem from other financial instruments, and as such the underlying value is directly connected to another asset, such as a stock. There are two main types of derivatives: puts and calls. A put is the right, but not the obligation, to sell a stock at a predetermined price referred to as the strike price. A call is the right, but not the obligation, to buy a stock at a predetermined strike price. Both puts and calls provide investors with insurance against a stock price going up or down. In essence, all derivative products are insurance products, especially credit derivatives.
- 5. EXAMPLE FOR CREDIT DERIVATIVE • There are many types of credit derivatives including credit default swaps (CDS), collateralized debt obligations (CDO), total return swaps, credit default swap options and credit spread forwards. In exchange for an upfront fee, referred to as a premium, banks and other lenders can remove the risk of default entirely from a loan portfolio. As an example, assume company A borrows $100,000 from a bank over a 10-year period. Company A has a history of bad credit and must purchase a credit derivative as a condition of the loan. The credit derivative gives the bank the right to "put" or transfer the risk of default to a third party. In other words, in exchange for an annual fee over the life of the loan, the third party pays the bank any remaining principal or interest on the loan in case of default.
- 6. EXAMPLE FOR CREDIT DERIVATIVE • If company A does not default, the third party gets to keep the fee. Meanwhile, company A receives the loan, the bank is covered in case of default on company A, and the third party earns the annual fee. Everyone is happy. • The value of the credit derivative is dependent on both the credit quality of the borrower and the credit quality of the third party, referred to as the counterparty. However, the credit quality of the counterparty is more important than the borrower. In the event the counterparty goes into default or cannot honor the derivatives contract, the lender does not receive a payment and the premium payments end.
- 7. TYPES OF CREDIT DERIVATIVES • A credit derivative is a financial instrument that transfers credit risk related to an underlying entity or a portfolio of underlying entities from one party to another without transferring the underlying(s). The underlyings may or may not be owned by either party in the transaction. The common types of credit derivatives are Credit Default Swaps, Credit Default Index Swaps (CDS index), Collateralized Debt Obligations, Total Return Swaps, Credit Linked Notes, Asset Swaps, Credit Default Swap Options, Credit Default Index Swaps Options and Credit Spread Forwards/Options.
- 8. TYPES OF CREDIT DERIVATIVES
- 9. CREDIT DEFAULT SWAPS A credit default swap is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting.
- 10. CREDIT-LINKED NOTES A credit linked note is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs.
- 11. CREDIT OPTIONS • A credit spread option is a financial derivative contract that transfers credit risk from one party to another. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level.
- 12. CREDIT INTERMEDIATION SWAPS • A credit default swap with the notional linked to the mark-to-market of a reference swap or portfolio of swaps.It is also called a credit intermediation swap.
- 13. CDS INDEXES • A credit default swap index is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities.This means that it can be cheaper to hedge a portfolio of credit default swaps or bonds with a CDS index than it would be to buy many single name CDS to achieve a similar effect.
- 14. TOTAL RATE OF RETURN SWAPS • A total return swap is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains.
- 15. SYNTHETIC CDOs • A synthetic CDO is a collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other noncash assets to obtain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed.
- 16. BASKET CREDIT DEFAULT SWAP • A basket default swap is similar to a single entity default swap except that the underlying is a basket of entities rather than one single entity. ... Similarly, an all-to- default swap protects against losses resulting from credit events of any of the entities in the basket.
- 17. CONCLUSION • In 1998, the most crucial challenge faced by the credit derivatives market at the time: the creation of liquidity. How much ground has been covered over the past seven years! • Several factors have contributed to the increase in liquidity on the CDS market, and they have ensured that CDSs have become mainstream capital market instruments. These factors include: • Standardization of legal contracts. • Clarification of the regulations (for banks). • Advances in information technology, risk management processes and trading infrastructures. • Emergence of market standards for structuring, modeling and pricing.
- 18. CONCLUSION • The unprecedented default wave of 2001–2002 also challenged the resilience of the credit derivatives market and proved its solidity. This ‘baptism of fire’ gave credit derivatives a central role in the capital markets, which will no doubt grow in the years to come. Their strong growth has in turn broadened the range of applications and number of users, and further fuelled product innovation. • It is very likely that the credit derivatives market will grow in an already-established pattern, like that followed by interest rate, currency and equity derivatives: pioneered by banks, often for their own needs, these other forms of derivatives were then offered to a sophisticated customer base of institutional investors, before being extended to the ‘mass market segments’ of corporates, retail and private banking investors. ...