Credit derivatives contracts

The rapid rise in use of credit derivatives has contributed to the liquidity and depth of this market worldwide. It has also fostered the adoption of standardized terms and definitions. Terminology and definitions in credit derivative contracts have been developed and harmonized in recent years and assisted in the takeup of these products by a variety of financial and nonfinancial institutions. The need for appropriate credit derivatives definitions have been considered by the International Swaps and Derivatives Association (ISDA). ISDA s definitions and terms are used in the confirmations and termsheets for most credit derivative transactions. 

For credit derivative contracts in which the payout is on credit events other than default, the modeling of the credit evolutionary path is critical. If, however, a credit derivative contract does not payout on intermediate stages between the current state and default then the important factor is the probability of default from the current state. 

Cash settlement represents another method of settling credit derivative transactions. In cash settlement, the protection buyer will receive an amount based on the difference between par and the valuation of the reference asset at a given valuation date, as agreed in the credit default swap contract. 

The legal department of most firms that buy or sell credit derivative instruments carefully monitor the terms of the transaction and in particular will focus on any nonstandard terms. In most cases the market will trade on standard ISDA documentation (terms and definitions). Sources of dispute, which are rare, may arise on the actual contract terms the nature of credit events, the obligation selected by the protection buyer for delivery. 

In Europe and Asia, the standard credit default swap contract used the restructuring definition (sometimes referred to as old restructuring ), whereas in the North American markets the standard credit default swap contracts refer to modified restructuring. The 1999 ISDA Credit Derivative Definitions would have been effective until early 2003. The 2003 ISDA Credit Derivative Definitions, which were in place in early 2003 (implementation in May 2003), have implemented some key amendments to the 1999 definitions, some of which were previously included in supplements issued by ISDA. 

Credit derivatives are financial contracts designed to reduce or eliminate credit risk exposure by providing insurance against losses suffered because of credit events. The loan or bond carrying the credit risk in question is the ref-... 

To act as market makers or traders in credit derivatives. Credit derivative traders may or may not hold the reference assets directly, depending on their appetite for risk and the liquidity of the market they would need to use to hedge their derivative contracts. 

The most common credit derivative, and possibly the simplest, is the credit default swap—also known as the credit or default swap. As diagrammed in FIGURE 10.4, it is a bilateral contract in which a protection seller, or guarantor, in return for a periodic fixed fee or a onetime premium agrees to pay the beneficiary counterparty in case any of a list of specified credit events occurs. The fee is usually quoted as a percentage of the nominal value of the reference asset or basket of assets. The swap term does not have to... 

Credit-linked notes, or CLNs, are known as funded credit derivatives, because the protection seller pays the entire notional value of the contract up front. In contrast, credit default swaps pay only in case of default and are therefore referred to as unfunded. CLNs are often used by borrowers to hedge against credit risk and by investors to enhance their holdings yields. 

The cash flows receivable from or payable to a hedge counterparty under swap agreements or derivative contracts The premium received from the credit default swap counterparty... 

The index tranche product is an OTC derivative market and a pure synthetic form of corporate credit CDO exposure. The tranche market has been established so that the trade is a bilateral contract between the dealer and the investor. The term single tranche synthetic CDO is often used to describe an index tranche exposure. However, as a result of the contract, the dealer is exposed to the risk (credit, market, and operational) of managing the contract. 

---