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Encyclopedia > Credit derivative
Financial markets

Bond market
Fixed income
Corporate bond
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Bond valuation
High-yield debt
In economics a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect efficient markets. ... Download high resolution version (480x640, 110 KB)Blockade in front of NYSE. Picture taken in April 2004. ... The bond market, also known as the debit, credit, or fixed income market, is a financial market where participants buy and sell debt securities usually in the form of bonds. ... This article does not cite any references or sources. ... A corporate bond is a bond issued by a corporation. ... A government bond is a bond issued by a national government denominated in the countrys own currency. ... In the United States, a municipal bond or muni is a bond issued by a state, city or other local government, or their agencies. ... Bond valuation is the process of determining the fair price of a bond. ... To meet Wikipedias quality standards, this article or section may require cleanup. ...

Stock market
Stock
Preferred stock
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Stock exchange
A stock market is a market for the trading of company stock, and derivatives of same; both of these are securities listed on a stock exchange as well as those only traded privately. ... This article does not cite any references or sources. ... A preferred stock, also known as a preferred share or simply a preferred, is a share of stock carrying additional rights above and beyond those conferred by common stock. ... Common stock, also referred to as common shares, are, as the name implies, the most usual and commonly held form of stock in a corporation. ...

Foreign exchange market
Retail forex
The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. ... The Retail Forex (Retail Currency Trading or Retail Forex or Retail FX) market is a subset of the much larger Foreign exchange market. ...

Derivative market
Credit derivative
Hybrid security
Options
Futures
Forwards
Swaps
A derivatives market is any market for a derivative security, that is a contract which specifies the right or obligation to receive or deliver future cash flows based on some future event such as the price of an independent security or the performance of an index. ... Definition A hybrid security, as the name implies, is a security that combines two or more different financial instruments. ... In finance options are types of derivative contracts, including call options and put options, where the future payoffs to the buyer and seller of the contract are determined by the price of another security, such as a common stock. ... In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. ... This article does not cite any references or sources. ... This article or section is in need of attention from an expert on the subject. ...

Other Markets
Commodity market
OTC market
Real estate market
Spot market
Chicago Board of Trade Futures market Commodity markets are markets where raw or primary products are exchanged. ... Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, or derivatives directly between two parties. ... Real estate is a legal term that encompasses land along with anything permanently affixed to the land, such as buildings. ... Template:The Spot Market The Spot Market or Cash Marketis a commodities or securities market in which goods are sold for cash and delivered immediately. ...

Valuation and Theories
Market Valuation
Financial market efficiency
Financial market efficiency is an important topic in the world of Finance. ...


Finance series
Financial market
Financial market participants
Corporate finance
Personal finance
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Banks and Banking
Financial regulation
This article does not cite any references or sources. ... In economics a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect efficient markets. ... There are two basic financial market participant catagories, Investor vs. ... Domestic credit to private sector in 2005 Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. ... Personal finance is the application of the principles of finance to the monetary decisions of an individual or family unit. ... Public finance (government finance) is the field of economics that deals with budgeting the revenues and expenditures of a public sector entity, usually government. ... “Banker” redirects here. ... Financial supervision is government supervision of financial institutions by regulators. ...

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Contents

General Definition

A credit derivative is a financial instrument or derivative (finance) whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded."[1] Credit default products are the most commonly traded credit derivative product[2] and include unfunded products such as credit default swaps and funded products such as synthetic CDOs (see further discussion below). Derivatives traders at the Chicago Board of Trade. ... A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of (at least one) third party entity. ...


Credit derivatives in their simplest form are bilateral contracts between a buyer and seller under which the seller sells protection against certain pre-agreed events occurring in relation to a third party (usually a corporate or sovereign) known as a reference entity; which affect the creditworthiness of that reference entity. The reference entity will not (except in certain very limited circumstances) be a party to the credit derivatives contract, and will usually be unaware of the contract's existence.


Where credit protection is bought and sold between bilateral counterparties this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative. Securitization is a financing process in which a corporate entity moves assets to an ostensibly bankruptcy-remote vehicle to obtain lower interest rates from potential lenders--because the assets cannot be seized in a bankruptcy proceeding, the risk is less for lenders and they are willing to offer a lower...


This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name but a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite. A credit linked note is a security created through a special purpose company or trust, designed to offer investors par value at maturity unless a referenced credit defaults. ...


Market Size and Participants

The ISDA[3] reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). The International Swaps and Derivatives Association (ISDA) is a voluntary consortium of major derivative players that created and maintain a standard derivative contract. ...


Although the credit derivatives market is a global one, London’s market share rests at about 40 per cent., with the rest of Europe standing at about 10 per cent.[2]


The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates. [2]


Types of Credit Derivative

There are many types of credit derivatives. Credit derivatives are fundamentally divided into two categories of product, funded credit derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. In a funded credit derivative, the credit derivative will be embedded into a bond (which will usually either be issued by an SPV or a financial institution), and bondholders will (ultimately) be responsible for the payment of any cash or physical settlement amounts.


Unfunded credit derivative products include the following products:

  1. Total return swap (TRS)
  2. Single name Credit default swap (CDS)
  3. First to Default Credit Default Swap
  4. Portfolio Credit Default Swap
  5. Secured Loan Credit Default Swap
  6. Credit Default Swap on Asset Backed Securities
  7. Credit default swaption (CDS)
  8. Recovery lock transaction
  9. Credit Spread Option
  10. CDS index products
  11. Constant Maturid Credit Default Swap (CMCDS)

Funded credit derivative products include the following products: Total return swap, or total rate of return swap, or TRORS, a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness... A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of (at least one) third party entity. ... To meet Wikipedias quality standards, this article or section may require cleanup. ...

  1. Credit linked note (CLN)
  2. Synthetic Collateralised Debt Obligation (CDO)
  3. Constant Proportion Debt Obligation (CPDO)
  4. Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

Unfunded credit derivative products

Total return swap

Main article: total return swap

A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets. Total return swap, or total rate of return swap, or TRORS, a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness... In the field of derivatives, a popular form of swap is the interest rate swap, in which one party exchanges a stream of interest for another partys stream. ... Nominal or notional amounts outstanding are defined as the gross nominal or notional value of all deals concluded and not yet settled on the reporting date. ...


The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset. This article needs additional references or sources for verification. ...


The essential difference between a total return swap and a credit default swap (qv) is that the credit default swap provides protection against specific credit events. The total return swap protects against the loss of value irrespective of cause, whether default, widening of credit spreads or anything else i.e. it isolates both credit risk and market risk. A credit event is an event such as: One party defaulting on pre-agreed payments to another party (e. ... Credit spread is the difference in yield between different securities due to different credit quality. ...


Credit default swap

Main article: credit default swap

The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market[2]. A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of (at least one) third party entity. ...


A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfil certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.


The relevant credit events specfied in a transaction will usually be selected from amongst the following: the bankruptcy of the reference entity; its failure to pay in relation to a covered obligation; it defaulting on an obligation or that obligation being accelerated; it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.


If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle.


This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness).


Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss. The protection seller has no recourse to and no right to sue the reference entity for recovery.


The product has many variations, including where there is a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities or Credit Default Swaps on Asset-Backed Securities"[4].


CDS options

A CDS option represents the right but not the obligation to buy or sell protection on an underlying reference credit at a specified strike spread at a specified date in the future. There are two types of options that can be bought or sold:

  • the right to buy credit protection (payer option)
  • the right to sell protection (receiver option)

CDS options can also have a special feature called a knock-out clause. A knock out clause refers to a situation where following a credit event by the underlying credit occurs before the expiry date of the option and the CDS option knocks out.


Funded credit derivative products

Credit linked notes

In this example you can see the coupons from the bank's portfolio of loans is passed to the SPV which uses the cash flow to service the credit linked notes.
In this example you can see the coupons from the bank's portfolio of loans is passed to the SPV which uses the cash flow to service the credit linked notes.

A credit linked note is a note whose cash flow depends upon a credit event, which can be a default, credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note. Image File history File linksMetadata Securitisation. ... Image File history File linksMetadata Securitisation. ... This article does not cite any references or sources. ...


A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its regular-note features, a CLN is an on-balance-sheet asset, in contrast to a CDS.


Typically, an investment fund manager will purchase such a note to hedge against possible down grades, or loan defaults.


Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. Here we are going to provide an overview rather than a detailed account of these instruments.


The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk.


For example, a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank runs into difficulty, their investments will suffer even if the country is still performing well.


The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.


Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.


There are several different types of securitized product, which have a credit dimension. CLN is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.

  • Credit Linked Notes CLN: Credit Linked Note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
  • Collateralized Debt Obligation CDO: Generic term for a bond issued against a mixed pool of assets - There also exists CDO-squared (CDO^2) where the underlying assets are CDO tranches.
  • Collateralized Bond Obligations CBO: Bond issued against a pool of bond assets or other securities. It is referred to in a generic sense as a CDO
  • Collateralized Loan Obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO

CDO refers either to the pool of assets used to support the CLNs or, confusingly, to the CLNs themselves. A credit linked note is a form of funded credit derivative. ... Collateralized debt obligations (CDOs) are a type of asset-backed security or structured finance product. ...


Collateralized debt obligations (CDO)

Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. This exposure is sold in slices of varying risk or subordination - each slice is known as a tranche. Collateralized debt obligations (CDOs) are a type of asset-backed security or structured finance product. ... In structured finance, the word tranche (sometimes traunche) refers to one of several related securitized bonds offered as part of the same deal. ...


In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer. Alternatively in a synthetic CDO, the exposure to each underlying company is a credit default swap. A synthetic CDO is also referred to as CSO. In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. ... A loan is a type of debt. ... A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of (at least one) third party entity. ...


Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared. In structured finance, the word tranche (sometimes traunche) refers to one of several related securitized bonds offered as part of the same deal. ...


Risks

Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. (The incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.) The Federal Reserve System is headquartered in the Eccles Building on Constitution Avenue in Washington, DC. The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central bank of the United States. ... For the record label, see Incentive Records. ...


See also

This article or section is in need of attention from an expert on the subject. ... Credit derivatives risks are a concern among regulators of financial markets. ... A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of (at least one) third party entity. ...

External links

Gabriel Kolko (born 1932) is a historian and author. ...

Notes and references

  1. ^ {{cite http://www.mayerbrownrowe.com/london/practice/article.asp?pnid=1571&id=3648&nid=1575 PLC magazine, Derivatives Uncovered: swaps, futures and all that jazz, by Edmund Parker}}
  2. ^ a b c d {{cite http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf British Banker Association Credit Derivatives Report}}
  3. ^ {{cite http://www.isda.org
  4. ^ {{cite http://www.mayerbrownrowe.com/london/publications/article.asp?id=3517&nid=369=delay Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer, Brown, Rowe & Maw}}

  Results from FactBites:
 
Credit derivative - Wikipedia, the free encyclopedia (3398 words)
A credit derivative is a contract (derivative) to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset.
There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognised in the income statement on a similar basis as the underlying assets and liabilities.
The pricing method is approximate in that it ignores the credit risk of the CDS seller, who may be unable to buy the bond in the event of default (suppose in an extreme case that the seller is also the issuer of the bond which is protected).
Credit Risk (7251 words)
Credit ratings are vital to the credit industry because they offer consistent and publicly available credit scores, produced by independent agencies, for either the creditworthiness of a major entity or for a particular debt security or other financial obligation.
Credit risk exposure measurement is especially important for lenders that extend lines of credit, as opposed to outright loans, and also to banks with portfolios of derivatives that have ever-changing and volatile credit exposures.
The first credit derivatives were traded in the early 1990s, but it is only in the last couple of years that their appeal has expanded from a few leading banks, dealing among themselves, to encompass broader sections of the financial markets and a wider range of uses.
  More results at FactBites »

 
 

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