Credit derivative are contracts where the payoff depends on the creditworthiness of one or more commercial or sovereign entities , credit derivative allow companies to manage their credit risk actively.
According to the definition, the use of the derivative security determines whether the derivative is a credit derivative or not. A simple derivative contract like a forward contract on a defaultable bond may be credit derivative to one counter party risk.(because he intends to use it to manage credit risk) and not a credit derivative to another.
Credit derivative bilateral contract between debtor and creditor.It allows the creditor to transfer the risk of the debtor default to a third party.
What are derivatives?
As the name suggests derivatives are based on or derived from an underlying asset and the way to evaluate derivatives is to value an equivalent structure of assets (or liabilities)
All derivatives are redundant because they can be replicated with a bundle of straight forward basic operations.Derivative have one decisive advantage over the underlyining bundle of assets and that is transaction costs.
It is not an uninteresting perspective to look at stocks and bonds as primitive options.
How credit derivative works
A credit derivative can remove the risk of default. Lender and borrower both can use it. By use of credit derivative banks has the right to transfer the risk of default to the third party.
Type of credit derivative
Credit default swap(CDS)
Total return swap
Credit spread option
Credit default swap->A credit default swap (CDS) is a contract that provides insurance against the risk of default by a particular company.The company is known as the reference entity and default by the company is known as the reference entity and default by the company is known as a credit event.The buyer of the insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event occurs. The bond is known as the reference obligation and the total par value of the bond that can be sold is known as the swap’s notional principal.
The buyer of CDS makes periodic payments to the seller until the end of the life.If the CDS or until a credit event occurs.
Credit derivative allow companies to manage their credit risk actively.
a)Binary credit default swaps-> Binary credit default swap can be quite sensitive to the expected recovery rate estimate. This is structured similarly to a regular credit default swap. Except that the pay of is a fixed dollar amount. In this case, the expected recovery rate affects the probability of default but not the payoff. As a result, the credit defaults spread is quite sensitive to the recovery rate.
b)Basket credit default swaps-> In a basket credit default swap there are a number of reference entities.An add-up basket credit default swaps.One an each reference entity.A first to default swap provides a payoff only when the first reference entity defaults.
2)Total return swaps->A total return swap is an agreement to exchange the total return a bond or other reference assets for LIBOR plus a spread. The total return includes coupons interest and the gain or loss on the assets over the life of the swap.A total return swap always used as a financing tool.
The payer retains ownership of the bond swap and has much less exposure to the risk of the receiver defaulting than it would have if it had lent money to the receiver to finance the purchase of the bond. The total return swap is similar to repos. They are structured to minimize credit risk when money is borrowed.
There are number of variation on the change in value of the bond.there physical settlement where the payer exchange the underlying asset for the notional principal at the end of the life of the swap.Sometimes the change in value payments are made periodically rather than all at the end.
3)Credit spread options->Credit spread option are options where the pay off depends on either a practical credit spread or the price of a credit-sensitive asset. Typically the options are structured so that they ease to exist if the underlying assets default. If a trader wants protection against both an increase in a spread and a underuritylying asset defaults then both credit spread option and another instrument such as credit default swap are required one type of credit spread option is defined so that it has a payoff of.
where is a particular credit spread at option maturity
Another type of credit spread option is a European call or put option on a credit sensitive asset such as a floating rate note.