CREDIT DERIVATIVES FOR BEGINNERS

How Credit Derivatives are Being Used

TO TAILOR INVESTMENTS

Using credit derivatives to tailor investments can involve complex applications making new asset classes accessible to investors for whom administrative complexity or restrictions imposed by borrowers have traditionally presented barriers. Or they can be used to isolate recovery rate expectations and interact to mutual benefit with a counterparty with a different expectation.
A more straightforward example involves tailoring an investment's term. It is often difficult for investors to tailor the term of investments to meet their own needs, or to extract value for developing focused views on the term structure of credit risk. Consider an exposure to a corporation that does not issue debt in less than eight-year increments. The predominance of investors limited to terms inside five years and the absence of shorter term debt than eight years, means that the term structure of credit spreads is likely to reflect a tighter spread for the first five years and a wider spread for the last three than would be otherwise expected. In other words, the term structure reflects a technical imbalance between supply of and demand for shorter term versus longer term paper.
Credit derivatives offer negotiable maturity profiles. Using a Credit Swap, it is possible to break an eight-year position into a five-year position and a three-year position. A bank investor limited to five-year terms is able to take the first five years of risk, while another investor is able to take the last. Both investors are satisfied since the forward investor is able to focus his exposure in the area in which he is able to extract most value for his view, while the other investor is able to generate an exposure not otherwise available in the cash markets.

TO EXPLOIT RELATIVE VALUE

From an investor's perspective, credit derivatives may be valuable simply by providing credit exposure in a form that would not otherwise be available. However, where alternative investments offer essentially similar risks, an investor needs to ascertain relative value to justify using credit derivatives instead of more traditional or more liquid assets.
The corollary is the opportunity to exploit any relative value. Methodologies of varying complexity have been developed to help decide whether a derivative is an attractive investment in a given situation.

NOTE ON COUNTERPARTY CONSIDERATIONS AND PRICE

In a Credit Swap, the Protection Buyer must deal with another type of risk, that of the Protection Seller defaulting. Implications for the Buyer range from having to find alternative protection, to facing the situation where both the Reference Entity and the Protection Seller default. This affects pricing. Protection bought from higher-rated counterparties will involve a higher premium. Correlations between the Reference Entity and the Protection Seller which make simultaneous default more likely suggest lower premiums - protections bought from one bank against another bank in the same country, for example.