Question 2

Introduction

The emergence of credit derivatives started in the 1990’s. The development of credit
derivative is relatively small compared to other derivative markets but however growing
speedily.

“Credit derivatives are contracts that transfer an asset’s risk and return from one counterparty
to another without transferring ownership of the underlying asset”. (Kiff and Morrow, 2000)

Under credit derivatives, the underlying asset mostly consist of corporate bonds, bank loans
and sovereign debts. Credit derivative markets are largely unregulated. Credit derivative
market has evolved in recent years but however traded or negotiated in over the counter
(OTC) market. The credit derivative market is highly decentralized. (Nyberg, 2007)

Types of Credit Derivatives

All types of derivatives can be structured as off-balance sheet derivative contracts fixed in
on-balance sheet structure. The major types of Credit Derivatives;

1. Credit Default Swaps

Credit Default swaps is a type of credit derivative that transfer the potential loss on an
underlying asset that can result from specific credit events like insolvency, credit default,
Credit-rating downgrade and bankruptcy. Credit Default Swaps are comparable to insurance
policies however used to protect against default of high-risk corporate debt, sovereign debt,
bonds, collateralized debt obligations and mortgage-backed securities.

2. Total Return Swaps

It is the type of credit derivatives that transfer the returns and risks on an underlying asset
from one party to the other. It is used as credit risk management tools, and also as synthetic
repo instruments for funding purposes. The total return from the underlying asset is paid to
the other party in return for a fixed or floating cash flow. (Choudhry, 2004)

3. Credit Spread Options

Credit spread option is a strategy which involves selling and buying options of reference asset
having the same maturity but different strike prices in a manner that it results in a net credit
of premium when the strategy is being arranged with the expectation that the spread will
narrow during the tenure of the strategy, resulting in a profit. (Kiff and Morrow, 2000)

4. Credit-Linked Notes

Credit Linked notes are securities in the form of credit default swap structure that enables the
issuer to transfer credit risk to the other party. It is normally issued through special purpose
trusts. This suggests that investors buy credit notes through the trust and pays either a fixed or
floating coupon over the life of the bond.

Market Participants of Credit Derivatives

The major dealers as estimated by Fitch Ratings (2005) were Morgan Stanley, Deutsche
Bank, Goldman Sachs, JP Morgan Chase and UBS. End-users of credit derivatives include
hedge funds, insurance companies, pension fund and mutual funds.

Relevance of Credit Derivatives to Modern Financial System

The relevance of credit derivatives can be derived from the perspective of the market
participants.

Banks

Credit derivatives are attractive means for banks to transfer credit risk unlike loan sales and
securities because it does not require the credit facility to be sold until a credit event arises.
This enhances the administration of loans for banks. In the current financial system, financial
institutions such as banks will need credit derivatives as it allows the management of credit
risk separately from decisions about funding. Banking services can be enhanced through
credit derivatives by means of a wider trend among banks to separate out their services in
order to price them appropriately.

Non-Financial Institutions

There is potential for non-financial institutions in the financial system as a result of credit
derivatives. Non-financial institutions like telcos could use credit default swaps to purchase
protection against credit risk. Their credit exposure could be managed as a result

Insurance Companies, Pension and investment funds

Credit derivative can be of great essence to insurance companies, pension and investment
funds since they can sell protection through investment in securities. Insurance companies
can invest in credit default swaps and credit linked notes together with bonds, equities and
other asset classes. For pension and investment funds, leveraged debt funds can purchase
higher risk and mezzanine tranches whiles senior tranches could be sold to pension funds.

Intermediaries

Intermediaries can use credit default swaps to manage credit risk in their activities. They can
purchase protection against counterparty risk emanating from the over-the-counter derivative
transactions. Credit default swaps can be an alternative to collateralization. (Rule, 2001)