- Managing "Illiquid" Credit Exposure
Markets are assuming an increased burden of credit exposure that is not particularly liquid. There is "illiquid" exposure that is not readily apparent because it is not associated with a standard, readily transferable credit instrument. Fixed-price supply contracts, trade receivables, or insurance contracts are a few examples. Or illiquidity of a credit risk may arise because relationship, regulatory, or tax considerations make it hard for the owner to liquidate the asset.
- Managing Client Relationships
Portfolio managers can find themselves locked into huge credit exposure arising from client transactions. Lending is a primary resource in maintaining client relationships, yet when the credit lines run out, banks are caught in a trap of their own making. Selling loans to free up capacity may be just as harmful to relations as refusing funding outright.
Banks can employ Credit Swaps to reduce credit exposure without physically removing assets from their balance sheet.
- Reducing Portfolio Concentrations
Concentration risk can arise from increased exposure to one credit, or it can arise from exposure to a group of highly correlated credits. Credits concentrated in one particular industry or a particular location would be an example of the latter kind of concentration or correlation. Portfolio uncertainty can be shown to be a function of the square of individual exposure sizes. Given this relationship, it is economically rational to pay a premium to reduce exposure to over-concentrated credits. Credit Swaps reduce targeted exposures.
- Credit Down-grades
A down-grade or anticipated down-grade by rating agencies will be reflected in the secondary market as liquid instruments drop in price. Portfolios of liquid assets may be forced to make mandatory sales. Even the holders of an illiquid loan portfolio may be required to recognize a loss. If loan holders cannot sell the underlying assets, the economic capital that needs to be set aside against these riskier assets will be greater. Preemptive measures can be taken by structuring a credit derivative to provide down-grade protection, reducing the risk of forced sales at distressed prices and enabling a portfolio manager to own assets of marginal credit quality at lower risk.
- Hedging Against Future Borrowing Costs
The use of credit derivatives to hedge dynamic exposure is a complex application beyond the scope of this introduction, but their use to hedge against future borrowing costs is relatively straightforward.
The desire to hedge the future costs of borrowing may reflect a wish to guard against or benefit from a narrowing or widening of the credit spread between debt instruments. Alternately, borrowers may wish to lock in future borrowing costs without inflating their balance sheet today.
An acceptable hedge in these situations is a Credit Spread Forward in which a Protection Buyer would receive the difference between a floating spread of the Reference Security and some benchmark yield and the strike, if positive, and would pay the difference, if negative.
