Credit Derivatives: Definition & Types

Instructor: Usha Bhakuni

Usha has taught high school level Math and has master's degree in Finance

In this lesson, you will become familiarized with the concept of credit derivatives and how they are used. You will also explore the popular types of credit derivatives used.

Credit Derivatives

Imagine that a pension fund, PF, wants to earn higher returns on its money by lending to corporations. This pension fund handles people's retirement money and can only invest in safe securities that are rated AAA. Now, let's say that the company ABC wants to borrow money but it is only rated BB. Since BB-rated securities are riskier than AAA rated ones, if PF wants to invest in ABC it will have to think of a way around this roadblock. Here, credit derivatives come to the pension fund's rescue.

Credit derivatives are financial instruments that transfer credit risk of an underlying portfolio of securities from one party to another party without transferring the underlying portfolio. Let's break this down to get a clearer picture.

When a lender lends money to a borrower, the lender is faced with the risk that the borrower won't pay that money back. This is called the credit risk. It determines the credit ratings of the bonds issued by companies to raise debt.

Credit Risk
Credit Risk

So, how is the credit risk transferred? The lender sells this loan to other parties who are seeking to invest in debt securities. These buyers get interest payments from the lender. Once the buyers purchase these special investment vehicles, the credit risk gets transferred to them, but the loans remain on the books of the original lender. These investment vehicles are what we call credit derivatives.

Credit Derivatives
Credit Derivatives

In our original example, PF cannot directly invest in the debt securities of ABC, but it can invest in AAA-rated credit derivatives issued by another lender of ABC. A word of caution: credit derivatives that are AAA-rated do not necessarily have underlying loans that are all AAA-rated. This increases the credit risk, as well as the interest rates, associated with these instruments.

Types of Credit Derivatives

There are two broad categories of credit derivatives:

  • Unfunded credit derivatives are instruments where the seller (lender) does not guarantee any payments to the buyers. The buyer gets paid only when the seller receives the loan repayments from borrowers. The buyer bears the entire credit risk.
  • Funded credit derivatives are instruments where the seller makes an initial payment to cover any future credit defaults. Therefore, the buyer is not exposed to the credit risk.

Now, let's look at the various types of instruments under each category.

1. Unfunded Credit Derivatives

1.1 Credit Default Swap (CDS)

In this derivative agreement, the party that sells the CDS pays regular interest payments to the buyer from the loan installments it receives from its borrowers. In return, the buyer agrees to pay the principal amount and any remaining interest in case a credit default occurs.

Under normal conditions, the arrangement looks like this:

CDS Under Normal Conditions

In the event of a credit default, the cash flow works as follows:

CDS Under Default
CDS in default

1.2 Credit Spread Swap Option

This is an option on a CDS. It means the buyer of the option has the right, but not the obligation, to buy or sell the CDS at a specified date, provided that no default occurs prior to this date. The buyer has to pay a premium to buy the option. If the underlying credit defaults, the option gets nullified. If there is no default event, the buyer might choose to buy the CDS if it offers a higher interest rate.

1.3 Total Return Swap (TRS)

In this derivative agreement, the two parties exchange both the credit and market risks. Let's assume a bank, which has given loan to a company, sells TRS to investors. The bank pays the interest income and capital gains coming from the company to these investors. In return, the investors pay a variable interest rate to the bank and also bear any losses incurred in the loan.

Total Return Swap
Total Return Swap

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