Basics of Credit Derivatives

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Credit derivatives: Types
by Vinod Kothari

Learn more on Credit Derivatives and Synthetic CDOs

Do consider buying Vinod Kothari's book on Credit Derivatives and Synthetic Securitisation, July 2002 edition - see here for details

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Based on the type of risk being transferred, credit derivatives may be broadly classed in

  • credit default swaps
  • total rate of return swaps
  • equity default swaps

In a credit default swap, the protection buyer continues to pay a certain premium to the protection seller, with the option to put the credit to the protection seller should there be a credit event. Unless there is a credit event, there is no exchange of the actual asset or the cashflows arising out of the actual asset.

In a total rate of return swaps, the parties agree to exchange the actual cashflows from the asset (say a bond), including the appreciation and depreciation in its market value, periodically, with returns referenced to a certain reference rate. Say, the reference rate is LIBOR. The protection buyer will get LIBOR + x bps, and pay over to protection seller all he earns from the reference assets. Thus, he replaces the returns from the reference asset by a return calculated on a reference rate - thereby transferring both the credit risk as well as the price risk of the reference asset.

Equity default swaps, relatively new in the marketplace, use a substantial and non-transient decline in the market value of equity as a trigger event - assuming that a deep decline in the market value of equity is either indicative of a default or preparatory for a default. For more on equity default swaps, see here.

Credit linked notes package a credit default swap into a tradable instrument - a note or a bond. The credit linked notes may be issued either by the protection buyer himself or by a special purpose vehicle.

A credit derivative may be reference to a single reference entity, or a portfolio of reference entities - accordingly it is called single name credit derivative, or portfolio credit derivative. In a portfolio derivative, the protection seller is exposed to the risk of one or more constituents in the portfolio, to the extent of the notional value of the transaction.

A variant of a portfolio trade is a basket default swap. In a basket default swap, there would be a bunch of names, usually equally weighted (say with a notional value of USD 10 million each). The swap might be, say, for first to default in the basket. The protection seller sells protection on the whole basket, but once there is one default in the basket, the transaction is settled and closed. If the names in the basket are uncorrelated, this allows the protection seller to leverage himself - his losses are limited to only one default but he actually takes exposure on all the names in the basket. And for the protection buyer, assuming the probability of the second default in a basket is quite low, he actually buys protection for the entire basket but paying a price which is much lower than the sum of individual prices in the basket.

Likewise, there might be a second-to-default or n-th to default basket swaps.