Back to Basics: An Introduction to Credit Derivatives

Teri Geske
Senior Vice President, Product Development

Introduction
Although some industry practitioners (often those who trade derivatives – no surprise there…), have been predicting explosive growth in the use of credit derivatives for some time now, in reality the market has evolved slowly as end-users, mostly banks, go through the process of learning how these instruments can help them manage credit risk in a new way. Banks have traditionally managed credit risk by establishing lending limits for each corporate borrower and at some level, aggregating this exposure by industry (and by country, where appropriate). Similarly, insurance companies and plan sponsors have managed credit risk by establishing "per issuer" limits in their investment policies, along with restrictions on quality ratings at the issue and overall portfolio level. A bank that wished to do additional business with a borrower that already reached the bank’s maximum authorized limit would either have to reduce its existing exposure to that borrower, possibly by selling some or part of an existing loan to another bank, or would have to decline the additional business opportunity. Neither of these alternatives were particularly attractive, as they both had the potential to damage the bank’s relationship with the borrower. Credit derivatives allow a bank or investor to "discreetly" reduce its credit exposure to a particular borrower – in other words, it can enter into a credit derivative transaction without informing the entity whose credit risk is the basis for the derivative contract. Conversely, a credit derivative can be used to increase exposure to a borrower when more traditional means, such as making a loan or buying a bond issued by the borrower, are not possible due to the limited size and relative illiquidity of the corporate loan and bond markets. In a more speculative use, credit derivatives offer a way to establish a negative position on a particular issuer, since shorting corporate debt is not practical.

There are three major types of credit derivatives: Credit (default) Swaps, Total Return Swaps and Credit Options. We briefly describe each one here:

Credit (default) Swap – In this transaction, one party (the "protection buyer") pays a periodic fee to a counterparty (the "protection seller") in exchange for some payment to be made if a referenced borrower experiences a "credit event," typically a default. For example, Bank X pays Derivatives Dealer Y a quarterly fee of n basis points, multiplied by some notional amount, in exchange for a payment in the event that Corporation Z defaults on its debt obligation(s). The payoff may be based on an observed market price of Corporation Z’s bonds after the default, or may be some fixed amount. Note that Corporation Z is unaware of the arrangement between the bank and the derivatives dealer. Credit swaps can be created not only with respect to corporate borrowers, they can also refer to sovereign debt, allowing investors to buy protection against default by foreign governments. Of course, there are many nuances and details regarding the definition of "default" and the pay-off alternatives that are specified in the swap contract.

Total Return Swap – Unlike an interest rate swap, where the parties exchange only interest rate payments based on a notional principal amount, in a Total Return swap one party pays the other the total return of a particular asset in exchange for a regular payment, typically at a floating rate based on LIBOR plus a spread. The "total return" includes interest payments from, along with any change in value of, the referenced asset over the specified horizon. Settlement can be a cash payment, or the contract may allow for physical delivery of the asset to the Total Return receiver. Note that the maturity of the swap contract need not (and rarely does) correspond to the stated maturity of the asset on which the total return calculation is based. A Total Return Swap could be used by an institution that owns an asset which cannot be sold for practical or business reasons, but that wishes to eliminate exposure to the risk of the issuer. As with a Credit Swap, the issuer of the underlying asset does not participate in and is typically unaware of the existence Total Return Swap.

Credit Options – These are put or call options on the value of a floating rate note, bond or loan (or on a "package" that consists of a fixed rate bond or loan and a derivative contract, typically an interest rate swap, that exchanges the fixed rate payment from the bond or loan for a floating rate payment). The credit option gives the buyer the right to sell (put) or buy (call) the floating rate asset to/from the counterparty at a pre-specified price (the strike price). If we assume that the price of a risk-free floating rate note is unaffected by changes in interest rates, we can see that the change in value of a risky floating rate asset is a function of credit spreads. Therefore, the price of a credit option is based on the volatility of credit spreads, rather than the volatility of interest rates. We can then see how credit options can be used to take a position on the direction of credit spread movements, even when it is not possible (perhaps due to limited supply) to buy the credit outright.