CREDIT DERIVATIVES

Credit derivatives are contracts where the payoff depends on the credit worthiness of one
or more commercial or sovereign entities. It enables banks and other financial institutions to
actively manage their credit risks. They can be used to transfer credit risk from one company to
another and to diversify credit risk by swapping one type of exposure for another.

All derivatives have some common features: they are related to some risk or volatility,
typically do not require initial investment, and may be net settled. For example, the risk or
volatility in an inter-rate swap is movements in interest rates. In a commodity derivative, it is
commodity prices. Likewise, the subject matter of a credit derivative is the general credit risk of
a reference entity. The general credit risk is indicated by the happening of certain events,
called credit events, which include bankruptcy, failure to pay, restructuring etc.

There is a party trying to transfer credit risk, called protection buyer, and the
counterparty is trying to acquire credit risk, called protection seller.

Features of credit derivatives:

 It is a bilateral, Taylor made and OTC contract between two parties, the protective buyer
and seller are required.
 The protection buyer purchases the protection by paying a price premium to the
protection seller.
 There is a reference or underlying asset whose risk is transferred.
 Credit risk of the asset may arise due to several factors, known as credit or risk events
such as bankruptcy, failure to pay, restructuring etc
 Settlement of credit derivatives between the counter parties may take place a physical
asset are in cash.
Credit Default Swaps

The most common credit derivative is a credit default swap. This is a contract where one
company buys insurance against another company defaulting on its obligations. The payoff is
usually the difference between the par value of a bond issued by the second company and its
value immediately after a default. Credit default swaps can be analyzed by calculating the
present value of the expected cost of the insurance in a risk-neutral world and the present value
of the expected payoff.

90 basis points per Year

Default Default
Protection Protection
Buyer Seller
Payment if default by reference entity

Total Return Swaps

In ordinary swaps, it is a simplest type of credit derivatives, and it was very similar to
ordinary transaction in TRS. The holder of security (Debt), promises to pay, total returns on the
security (interest rates) plus unrealized capital gain or loss, to another party, who promises to
swap, by paying a fixed return. There are features to TRS:

Total Return on Bound

Total Return Total Return

Payer Receiver

LIBOR + 25 basis points

 Protection buyer hedges the risk of the asset shown on the balance sheet, where as the
TRS makes the protection seller to bear the risk on the asset not shown in the balance
sheet.
 TRS must mature before or with the maturity of the underlying debt security.
  TRS covers not only credit risk on original borrowers, but also the market risk, the
market price of debt securities.
 TRS may be structured either for single asset or for portfolio of assets.

Credit Spread Option

A credit spread option is an option on a credit spread. Under one type of structure, the
payoff is calculated by comparing the credit spread in the market at a future time to a strike
credit spread option is defined so that it has a payoff of

D max ( K – St, 0) or D max (St – K, 0)

Under another, it is calculated by comparing the price of a floating-rate bond to a strike price.

max (St - K, 0) or max ( K – St, 0)

Collateralized Debt Obligation

In Collateralized debt obligations a number of different securities are created from a

portfolio of corporate bonds or commercial loans. There are rules for determining how credit
losses are allocated to the securities. The result of the rules is that securities with both very high
and very low credit ratings are created from the portfolio.

A credit derivative being a derivative, does not require either of the parties - the
protection seller or protection buyer - to actually hold the reference asset. Thus, a bank may buy
protection for an exposure it has, or does not have, or irrespective of the amount or term for
which it has actual exposure. Obviously, therefore, the amount of compensation that can be
claimed under a credit derivative is not related to the actual losses suffered by the protection
buyer.
TOPIC :- Credit Derivatives.

Presented by :- R.M.Pradeep Kumar & S.Arun Kumar.

Name : R.M Pradeep Kumar.

Roll No:2009PECMB044

College: Panimalar Engineering College.

Dept: MBA

EmailId: pradeepkumar.rm@gmail.com

Name : S.Arun Kumar.

Roll No:2009PECMB145

College: Panimalar Engineering College.

Dept: MBA

EmailId: arunsrinivass@gmail.com