CREDIT

DERIVATIVES
 Definitions

 Derivatives:- A financial contract that has its price derived

from, and depending upon, the price of an underlying asset.
 The underlying assets might be traded.

 Types of Derivatives include, Swaps, Options and Futures.

 Credit Risk:- The risk that a counterparty to a financial

transaction fail to fulfill their obligation.

 Credit Spread:- The different between the yield on the

borrower’s debt (loan or bond) and the yield on the
referenced benchmark such as U. S. Treasury debt of the
same maturity.
 Meaning of Credit Derivatives

 Privately held negotiable bilateral contracts that allow

users to manage their exposure to credit risk. Or
 An OTC derivative designed to transfer credit risk from
one party to another by synthetically creating or
eliminating credit exposures.

 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.
 Parties to credit Derivatives
 Protection Buyer: A party trying to transfer credit risk, called protection
buyer. In its simplest form, the protection buyer pays a periodic fee or
premium to the protection seller.
 Protection Seller: The counterparty is trying to acquire credit risk, called
protection seller. Where the protection seller agrees to compensate the
buyer for the loss incurred in the event of a default (or credit event) on the
reference obligation.
 Types of Credit derivatives

Credit Default Swap (CDS);

Credit Spread Option (CSO);

Credit Linked Note (CLN).

 Credit Default Swap

 Credit default swaps allow one party to "buy" protection

from another party for losses that might be incurred as a
result of default by a specified reference credit (or credits).

 The "buyer" of protection pays a premium for the

protection, and the "seller" of protection agrees to make a
payment to compensate the buyer for losses incurred upon
the occurrence of any one of several specified “credit
events”.
 Example of Credit Default Swap

Suppose Bank A buys a bond which is issued by a

Steel Company.

To hedge the default of Steel Company:

 Bank A buys a credit default swap from Insurance Company C.
 Bank A pays a fixed periodic payments to Insurance company
C, in exchange for default protection.
 Diagrammatic Presentation

Credit Risk

Premium Fee
Bank A Insurance Company C
Contingent Payment On
Buyer Credit Event Seller

Steel company
Reference Bond
 Credit Spread Option

A Credit Spread Option grants the buyer the right,

but not the obligation, to purchase a bond during a
specified future period at the contemporaneous
market price and to receive an amount equal to the
price implied by a “strike spread” stated in the
contract.
 Example of Credit Spread Option

An investor may purchase from an insurer an option

to sell a bond at a particular spread above LIBOR
Credit spread.

If the spread is higher on the exercise date, then the

option will be exercised.

Otherwise it will lapse.

Diagrammatic Presentation
Profit

Strike price

Spot price
 Credit Linked Note

 Credit Linked Note (CLN), also called a credit default note. It is a fixed or
floating rate note where the coupon and principal payments are referenced to a
reference credit, which can be a single or multiple names. If there is no credit
event of the reference credit, all the coupons and redemption value will be paid
in full. However, if there is a credit event, the payments of the note will be
altered.

 A Credit Linked Note (CLN) is essentially a funded CDS, which transfers

credit risk from the note issuer to the investor. The issuer receives the issue
price for each CLN from the investor and invests this in low-risk collateral. If a
credit event is declared, the issuer sells the collateral and keeps the difference
between the face value and market value of the reference entity’s debt.
 Example of Credit Linked Note

Suppose same Steel Company needs loan.

Bank A would extend a $1 million loan to the Steel

Company.

At same time Bank A issues to Institutional Investors an

equal principal amount of a credit-linked note, whose
value is tied to the value of the loan.

If a credit event occurs, Bank A’s repayment obligation

on the note will decrease by just enough to offset its loss
on the loan.
 Example of Credit Linked Note

$1 Million

Bank A Institutional investors

If defaults or bankruptcy
declares the investors
will receive an amount
equal to the recovery
50% rate.
Recovery
Rate
noilli mI $

Steel Company
Any Questions