Credit derivatives instruments

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. 

The following terminology may be nsed to describe the credit risk in bond positions ( cash instruments ) and credit defanlt swaps positions ( credit derivative instruments ) ... 

Credit-linked notes (CLNs) are the simplest of all credit derivative instruments. They are funded assets issued by a bank or other entity and have credit risk to a second issuer (the Reference Issuer). These notes pay an enhanced coupon to the investor for taking on the added credit risk. These are typically issued our of repackaging vehicles or EMTN programmes. 

CDO structures may be either conventional or synthetic. The conventional structures were the first to be widely used, but synthetic ones have become increasingly common since the late 1990s. The difference between the two structures lies in how they transfer credit risk from the originator to the SPV in conventional CDO structures, this is achieved by transferring assets in synthetic structures, credit derivative instruments are used. 

Although the products typically identify with structured credit seem extensive and often confusing, reflecting the numerous underlyings that are possible bonds, loans, credit default swaps, and so on versus CBOs, CLOs, CSOs, and so on. They all achieve a very similar value proposition they are vehicles to pool and redistribute risk. In many ways, all these products are best classified as derivative instruments given that they... 

Credit Derivatives are a relatively recent addition to the range of financial instruments used by banks and financial institutions. However, there has been strong growth in this innovative area of the capital markets. The British Bankers Association (BBA) estimates that at the end of 2001 the global market (excluding asset swaps) accounted for over 1 trillion. The projected growth rate for the global credit derivatives market is predicted to reach a 4.8 trillion by 2004. 

In this chapter we introduce the main types of credit derivatives, and describe their nses and applications. We also introduce concepts in pricing and valuation of these instruments. 

Asset swaps predate the introduction of the other instruments we discuss in this chapter and strictly speaking are not credit derivatives. However, they are used for similar purposes and there is considerable interplay between the cash and synthetic markets using asset swaps, hence the need to discuss them here. 

A credit-linked note (CLN) is a structured note that combines both a debt instrument and a credit derivative. The structured note includes an embedded credit derivative that isolates the credit risk of the reference asset in this way an investor in this type of structured note may be able to transform its credit risk exposure. The investor in this note makes a cash investment in a bondlike instrument and receives a return that is... 

Gup and Brooks (1993) noted that swaps credit risk, unlike their interest rate risk, could not be hedged. That was true in 1993. The situation changed quickly, however, in years following. By 1996 a liquid market existed in instruments designed for just such hedging. Credit derivatives are, in essence, insurance policies against a deterioration in the credit quality of borrowers. The simplest ones even require regular premiums, paid by the protection buyer to the protection seller, and make payouts should a specified credit event occur. 

As noted, credit derivatives may be used by investors to manage the extra risk they take on by opting for the higher returns of non—default-free debt. The instruments can also be used, however, to synthesize the exposure itself, if, for instance, compelling reasons exist for not putting on the cash-market position. Since credit derivatives are OTC products, they can be tailored to meet specific requirements. 

SPV usually enters into an interest rate swap. The swap counterparty may also sell the SPV other derivative instruments, such as interest rate caps, to manage possible cash flow risk. Such risk-exposure management requires careful attention, since the SPV s risk profile can have a significant impact on the credit risk of the notes issued to investors. In an unleveraged transaction, the size of the issue is equivalent to the credit protection the SPV offers on the reference pool of assets. For example, if the credit default swap is on a nominal of 300,000, the nominal value of the notes issued will be 300,000. 

Part Two, Cash and Derivative Instruments and Analysis, has an analysis of various instruments including callable bonds that feature embedded options. There is a discussion of securitization and the impact on the market of the financial crisis. Other chapters cover U.S. Treasury TIPS securities, and the use and applications of credit derivatives. 

In deriving the swap curve, the inputs should cover the complete term structure (i.e., short-, middle-, and long-term parts). The inputs should be observable, liquid, and with similar credit properties. Using an interpolation methodology, the inputs should form a complete, consistent, and smooth yield curve that closely tracks observed market data. Once the complete swap term structure is derived, an instrument is marked to market by extracting the appropriate rates off the derived curve. 

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