CREDIT DERIVATIVES FOR BEGINNERS

A Few Definitions and Structures

Vocabulary is still being standardized, but the following terms or close variations are in wide use.

 

PROTECTION BUYER Also known simply as the Buyer, the party paying a periodic fee in return for a contingent payment by the other party following a Credit Event of the Reference Entity.	PROTECTION SELLER Also known simply as the Seller, the party receiving a periodic fee in return for making a contingent payment to the other party following a Credit Event of the Reference Entity.	TOTAL RETURN SWAP A credit derivative in which the total return of an asset is exchanged for another cash flow. The Total Return Payer pays out the total return of the Reference Security or other asset, including interest, fees, and any capital appreciation (or depreciation, which results in a payment to the Payer). The Total Return (TR) Receiver makes a regular payment pegged to some empirical market indicator, plus a spread, effecting a synthetic financing of exposure to the underlying asset.
CREDIT EVENT For example, public information of a receivership, bankruptcy, insolvency, winding up or failure to meet payment obligations.	CREDIT SWAP A derivative in which the Protection Buyer pays a periodic fee, typically expressed in basis points on the notional amount, in return for a Contingent Payment by the Seller upon occurrence of a Credit Event of the Reference Entity. The Contingent Payment is designed, for example, to mirror the loss incurred by creditors of the Reference Entity in the event of its default.
CONTINGENT PAYMENT Payment by Protection Seller, usually determined using one of the following methods: Recovery-Linked Cash Settlement: Usually calculated as the fall in price of a Reference Entity below par, as established by polling dealers; Physical Delivery. Full notional amount in exchange for the Reference Securities. Final Workout Value: A cash settlement equal to the losses incurred by creditors of the Reference Entity based on the actual workout value of either a specified Reference Security or a broad class of obligations of the Reference Entity, as established in bankruptcy proceedings. Binary Cash Settlement: Predetermined, fixed amount, usually expressed as a percentage of the notional amount.
REFERENCE SECURITY Typically, a public security issued by the Reference Entity; alternatively a Reference Asset or Reference Obligation, such as a loan or other financial asset including swaps, trade receivables, indemnification letters and so on.		REFERENCE ENTITY, OR REFERENCE CREDIT A specified entity, which may be a sovereign, financial institution, corporation, or one among a basket of such specified entities.