An Introduction to Credit Derivatives

Most day traders will have dealt with derivatives in at least some form. Despite this, many have a very limited understanding of the different types of derivative that are commonly traded, or the financial and legal implications of these trades.

A derivative is where a contract’s value is determined by the value of an underlying asset or assets at a future date. A credit derivative is a type of derivative. Its price and value comes from the risk of debt obligations and/or creditworthiness of a third party.

There are many types of credit derivative. The most common examples are credit default swaps, credit index trades, credit spread derivatives and swaptions.

Who Uses Them?

Credit derivatives are an attractive proposition for institutions who want to limit or diversify credit risk in their debt portfolios. Credit derivatives also allow financial institutions to trade in credit risk and take, as profit, the difference between the buy and sell prices.

Further, credit derivatives can be used to comply with regulatory requirements. For example, governments often impose minimum capital requirements upon regulated financial institutions to protect the banking system from collapse. This regulation can force institutions like banks and insurance providers to hold minimum levels of capital against its risk exposure. The protection provided by credit derivatives, however, can mean that debt may be held by financial institutions but the amount of capital which must be held against the debt due to regulation can be drastically reduced.

Measuring Risk

The most common credit derivative trade is where a buyer purchases protection from a seller against the credit risk of a third party. The seller will assume the credit risk and the buyer will pay a premium. The premium will be based upon the credit risk as a percentage of the derivatives notional value. The higher the risk, the higher the percentage (and the premium) will be. The obligation may be specifically named debt security or it may be a category of obligation. The obligation and the notional amount of the credit protection against which the credit protection is provided will need to be established from the start of the relationship.

A specific credit derivative contract only trades in the risk of certain pre-agreed events occurring. There are various different types of credit risks that are known as “credit events”. These include bankruptcy, failure to pay and restructuring.Therefore it is also necessary for the buyer and the seller to decide what the minimum threshold will be and upon which "credit events" the protection will apply. There are presently six categories of credit events. Following reforms which are currently being considered by the International Swaps and Derivatives Association (IDSA), a seventh is expected to be introduced later this year.

Funded or Unfunded

Credit derivatives can be either "unfunded" or "funded ". An unfunded credit derivative is where the seller makes no upfront payment to cover its potential future liabilities. Funded credit derivatives are where the derivative is embedded in a bond or loan structure.

Credit derivatives documentation has largely been standardised by the ISDA. Typically it is made up of a Master Agreement (as amended by a schedule), the 2003 Definitions and a form of confirmation. The master and confirmation agreements set out the standard terms. The parties then produce supplemental documents for each individual transaction.

There are many risks associated with credit derivatives. For instance, if incorrect modelling is used or, if a credit derivatives portfolio is valued incorrectly, this can expose considerable market risk. In the credit derivatives market, prices may become distorted and more prone to fluctuation because it is not as liquid as other markets. Credit derivatives also are regularly given attention by regulatory bodies. Further, in unfunded credit derivatives transactions the buyer is exposed to the risk that the seller will not be in a position to pay the settlement amount leaving it without the credit protection that it had purchased. Poorly drafted documentation may mean that the derivative does not work as required or is not lawful or enforceable. Using the ISDA documentation correctly and seeking proper advice can remove many of the risks associated with credit derivatives.

Abigail Harding joined Derivatives Documentation Ltd in June 2008. She has 2 years’ credit derivatives confirmations and one year's middle office experience in structured credit derivatives for a large American investment bank. Since joining DDL she has worked on a number of in-house and outsourced assignments relating to ISDA and CSA negotiation.  She has also provided training on credit derivatives documentation.