CREDIT DERIVATIVES FOR BEGINNERS

How Credit Derivatives are Being Used

TO OPTIMIZE BALANCE SHEET USE

1. Funding

   Banks with high funding costs often buy risky assets to generate spread income. Consequently, they are open to an alternative that would take on credit exposure in off-balance-sheet positions that do not need to be funded. On the other hand, a bank with low funding costs may want to capitalize on this advantage by buying balance sheet assets. A Credit Swap may help both of them meet their objective. For the bank with the high funding level, there is no up-front principal outlay in assuming a Credit Swap position. This approach is becoming an important source of portfolio diversification for banks and institutional investors who would otherwise continue to accumulate concentrations of lower quality assets. And for a low-cost investor, the premium for buying protection on balance sheet assets may be less than the bank's spread over funding.

2. Economic Capital

   Consider a down-grade of a credit already in a loan portfolio. The expected loss on this position rises to reflect an increased probability of default. Higher expected losses directly affect loan-loss reserves, which are a counter-asset charge on the balance sheet. There is an indirect cost as well - further costs are incurred by the need to set aside more economic capital in recognition of the greater volatility in default probability for lower-rated credits. In other words, there is less confidence in loan loss projections since lower quality credits exhibit more disparate default behavior. Credit derivatives can provide a solution by reducing exposure and freeing economic capital, which may be used in more capital-efficient investments.

3. Total Return Swaps

   Occasionally a party has a reason to exchange the total economic performance of an asset for another cash flow without balance sheet impact. Alternately stated, the desire may be to effectively remove all economic exposure to an underlying asset for a given term, and perhaps to effect the transfer with confidentiality and without the need for a cash sale.
   Using a Total Return Swap, the TR Receiver can develop exposure to the underlying asset without the initial outlay required to purchase it. The maturity of the swap does not have to match the maturity of the underlying asset. The TR Receiver in a swap with maturity less than that of the underlying asset may benefit from the positive carry associated with being able to roll forward short-term financing of a longer term investment. The TR Payer may benefit from being able to purchase protection for a limited period without having to liquidate the asset permanently.