“ When they are employed wisely, derivatives make the world simpler because they give their buyers an ability to manage and transfer risk”- Carol Loomis
Credit derivatives are one of the many specialized derivatives that are used for the purpose of hedging, speculation and arbitrage. The primary purpose of a credit derivative or the need behind the creation of such a product is to serve as a credit risk transfer mechanism.
Credit risk is one of the four broadly classified types of risks (others being operational risk, market risk and liquidity risk). It is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.
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Financial institutions need to manage their financial risk so as to protect themselves from any kind of uncertainty and to adhere to the norms. While managing risk, the institution may choose to accept the risk, avoid the risk, reduce the risk or transfer the risk.
With credit risk, it is not possible to accept or avoid all of the risk and reducing the risk most certainly leads to a decrease in profitability of the institution. That is why transferring the credit risk is the most viable option with credit derivatives being the best method.
Credit derivatives are traded over-the-counter and so most of the participation is institutional (non-retail) as is evident by the need created for institutions to manage their credit risk. A retail investor might not need to encounter such derivatives, but they may choose to do so for speculation purposes.
In order to explore the fundamental instruments used for transferring credit risk, this blog delves into the four major types of credit derivatives.
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4 Types of Credit Derivatives
Credit Default Swap (CDS):
A credit default swap (CDS) allows a market participant to transfer his/ her credit risk to another market participant. If a lender is worried that borrower(s) might default, he may choose to buy a CDS in the over-the-counter (OTC) market and potentially offset his/ her credit risk to the CDS seller.
The CDS agreement is similar to an insurance agreement and a lender is insured of his/ her credit risk default by the CDS seller who acts as the insurer. Similar to insurance contracts, most of the CDS contracts have a periodic premium payment system.
The payoff of a CDS is contingent upon the performance of an underlying instrument as is true for all derivatives. The most common underlying instruments include corporate bonds, emerging market bonds, municipal bonds and mortgage-backed securities.
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Advantages of CDS:
Absorbs shocks: CDS enable lenders to engage in risky ventures especially in the corporate world. Lenders provide funds to risky borrowers who promise high returns and then protect them using CDSs which serve as shock absorber specially during a corporate crisis.
Increases liquidity: CDS contracts ultimately result in liquidity in the credit derivatives markets by providing an additional option to an investor for diversification created by any lender’s need.
Indicates financial health: CDS contracts have the prevailing financial health of the debtor factored in (according to the efficient market hypothesis). It serves a more accurate measure of credit risk than the periodically-published reports by the various credit agencies.
Disadvantages of CDS:
Encourages speculation: Due to the risky nature of such securities and the associated possibility of making substantial profits, CDS contracts attract speculators who can inflate the prices of such securities by increasing the demand and a subsequent increase in the CDS premium with respect to a particular entity.
Presents ambiguity: The underlying default event might be difficult to define in the contract which may result in conflicts eventually and which may result in substantial losses for the lender.
Can be manipulated: CDS contracts can be abused and manipulated, creating an illusion of protection for the buyer of the contract. Since, CDS contracts are traded in the markets, they might be transferred to a completely different entity.
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2. Collateralized Debt Obligations (CDO):
Collateralized debt obligations (CDOs) are structured products created by banks to offload risk. They form a type of structured asset-backed securities (ABS).
Usually the assets backing a CDO comprise a diversified portfolio of corporate and emerging market bonds, mortgage and non-mortgage backed securities, bank loans and credit default swaps along with other assets.
In order to create a CDO, investment banks repackage the diversified portfolio of cash flow-generating assets mentioned above into discrete classes using the waterfall structure which creates discrete tranches based on the level of credit risk assumed by the investor. The three commonly created tranches are:
Senior Tranche: As implied by the name, this is the tranche that is the senior most in superiority since it is the first to receive cash in case the portfolio of loans defaults. It is the safest of the three tranches and therefore offers the lowest interest rate.
Mezzanine Tranche: The mezzanine tranche is the middle tranche and is the second to receive cash. It offers a slightly higher interest rate than the senior tranche due to the same.
Junior Tranche: The junior tranche is the lowermost tranche that offers the highest interest rate since it is the riskiest trance due to the greater risk of default. In case the loans default, this tranche is the last to receive cash.
The riskiness associated with these tranches is reflected in their credit ratings.
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Advantages of CDO:
Increases flow of credit: When used responsibly, CDOs can be excellent financial tools that can increase the availability and flow of credit in the economy. By selling CDSs, banks are able to free up more funds that can be lent to other customers.
Provides options: CDOs take into account the different levels of risk tolerance among investors and provide options depending on the same.
Transforms illiquid assets to liquid assets: CDOs allow banks to transform relatively illiquid assets like bank loans into liquid assets.
Disadvantages of CDO:
Results in relaxed standards: CDOs can result in relaxed lending standards among banks as was seen in the 2007-09 financial crisis.
Creates liquidity problems: Speculative moves in the markets determined by emotions can result in standstill in trading of such derivatives, thereby creating a liquidity problem and financial loss for the investor.
3. Total Return Swaps:
A total return swap is a credit derivative that enables two parties to swap both the credit and market risks. In a total return swap, the payer is able to discreetly remove all the economic exposure to the asset without having to sell it. On the other hand, the receiver is able to access the economic pressure of the asset without having to buy it.
For example, a bank that lends money to a borrower and receives interest payments in exchange may buy a total return swap from an investor. In such an agreement, the bank would pay the fixed interest obtained from the loan and the capital gains in the loan to the investor who would pay a variable interest rate, generally some variable spread above the LIBOR, and the loss in debt in exchange.
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4. Credit Default Swap Option:
A credit default swap option or a credit default swaption (CDS option) is an option on a credit default swap (CDS). It gives its holder the right to buy or sell protection on a specified reference entity for a specified future time period for a certain spread.
CDS options are usually of 2 types:
Payer Swaptions: A payer swaption gives the buyer the option to buy protection. The buyer pays premiums in return.
Receiver Swaptions: A receiver swaption gives the option buyer the option to sell protection. The seller receives premiums.
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“Derivatives are financial weapons of mass destruction”-Warren Buffet
Credit risk is the earliest formulated risk constituting a major portion of the earlier editions of the Basel accords. Over the years, there have been several innovations leading to the development of credit derivatives. Credit derivatives form an extremely useful mechanism of credit risk transfer. They are widely used by financial institutions worldwide. This blog discussed the four major types of credit derivatives: Credit Default Swap (CDS), Collateralized Debt Obligation (CDO), Total Return Swap, Credit Default Swap Option (CDS Option).
It should be noted that credit risk is one of the earliest formulated risks and constituted a major portion of the earlier editions of the Basel accords. Over the years, there have been several innovations in this segment and credit derivatives constitute a segment of the outcome of these innovations.
The first use of credit risk derivatives were developed toward the end of the 20th century. In the run-up to the 2007-09 financial crisis, the market of credit derivatives was thriving. They, however, were beaten badly during the crisis and became infamous as the cause of the crisis. In hindsight, the problem was not in these derivatives but in the banner in which they were used.