Credit risk29 is arguably the most significant form of risk that capital market participants face (Finnerty:3). Credit derivatives30 emerged in the early 1990s as useful risk management tools. They enable market participants to separate credit risk from other types of risk such as currency risk or interest rate risk and to manage their credit risk exposures by selectively transferring unwanted credit risks to others. This uncoupling of credit risk from other types of risk created new opportunities for both hedging and investing. Credit derivatives are over-the-counter (OTC)31 derivative contracts the value of which derives, at least in part, from the credit performance of a reference asset32 (Herring, 1998:11). The reference assets could include bonds, bank loans or some other credit instrument. In essence, credit derivatives allow market participants to trade the credit risk embedded in reference assets and to construct synthetic investments with specific term and risk profiles.
Credit derivatives are new, although options that pay in the event of default have existed for many years, dating back to the introduction of bond insurance in 1971 (Finnerty:3). Letters of credit and guarantees, which pay in the event of default, have been around even longer. In their simplest form credit derivatives are very similar to letters of credit and guarantees (Watzinger, 1998:23). The difference is that letters of credit and guarantees are typically assigned to a specific transaction and
29 Credit risk refers to the risk that an asset such as a bond will lose value because of a reduction in the issuer’s capacity to
make payments of interest and principal. Default risk refers to the likelihood that the issuer will actually fail to make timely payments of interest and principal.
30 A derivative contract, or derivative for short, is a bilateral contract whose value derives from the value of some
underlying asset or index.
31 Meaning “direct between counterparties” or privately negotiated contract.
32 The terms reference asset and reference obligation is used interchangeably. A bank loan to a borrower (reference
cease to exist without it, whereas credit derivatives can transfer risk irrespective of an underlying exposure. With a credit derivative the reference entity, or borrower, whose risk is being transferred need neither be a party to, nor be aware, of a credit derivative transaction. This confidentiality enables users of credit derivatives such as banks to manage their credit risk discreetly without interfering with customer relationships. Since the borrower is not involved, the terms of the credit derivative transaction can be customised to meet the needs of the buyer and seller of risk, rather than the needs of the borrower. Moreover, because credit derivatives isolate credit risk from the relationship, credit derivatives introduce discipline to pricing decisions. Credit derivatives provide an objective market pricing benchmark representing the true opportunity cost of a transaction (JP Morgan:4).
The use of credit derivatives continues to expand and participants in this market include banks, corporates, hedge funds, insurance companies, asset managers, pension funds and structured finance vehicles. In the latest global survey by Fitch Ratings, the credit derivatives market grew from US $1.8 trillion in 2003 to US $3 trillion in 2004 (2004a:1). The growth to date, especially the rapid growth from 1998 onwards, has been driven by several factors. Banks, which are under increasing pressure to improve their financial performance, have turned to credit derivatives in order to manage the concentration and correlation risks in their loan portfolios more actively as well as managing the economic33 and regulatory capital required to support their operations. It was in the period following the Russian default in 1998 however, that the credit derivatives market seemed to come of age (Bowler and Tierney, 1999:3). Although the Russian crisis highlighted a number of documentation and administration problems, in most respects the credit derivatives market worked the way it was supposed to and illustrated how credit risk can be transferred between counterparties.
Another key factor that spurred the growth of credit derivatives was the standardised credit derivative definitions introduced in 1999 by the International Swaps and Derivatives Association (ISDA). These common set of definitions eliminated the documentation and legal risk that had existed up to that time due to a lack of standard terms and definitions. In 2003 ISDA published its new credit derivative definitions and master agreement (Cunningham et al., 2003:1).
33 Economic capital is the capital banks set aside as a buffer against potential losses inherent in any business activity e.g.
There are three basic ways to structure a credit derivative (Finnerty:4).
− The first is by linking a stream of payments to the total return on a specified reference asset. The total return receiver is exposed to the credit risk of the reference asset because this risk is embedded in the total return payment stream. A total return swap is an example of such a structure.
− The second is by basing the payoff on a specified credit event, such as a loan default or bond rating downgrade. The payer serves as an insurer and bears the credit risk associated with the credit event. A credit default swap is an example of such a structure.
− The third is by tying the payoff to the credit spread34 on a specified bank loan or bond. The seller of a credit spread put option serves as an insurer and bears the risk that the credit quality of the reference asset might deteriorate causing the credit spread on the reference asset to widen. A credit spread option is an example of such a structure.
The reference asset is frequently a credit obligation e.g. a loan or bond, although it may also be a portfolio or market index (Bowler and Tierney, 1999:19). Neither the buyer of protection nor the seller of protection needs to own obligations of the reference entity, although, if the contract is to be settled in the form of bonds or loans35, the protection buyer should be sure of being able to obtain them in the market and having the legal right to transfer them. The protection buyer sheds the risk of the reference entity, but bears the risk that the counterparty, the protection seller, will not perform either because of its inability to do so due to e.g. its insolvency, or because of legal disputes regarding the terms of the contract. The protection seller acquires the risk of the reference entity with the associated earnings, without having to service the client relationship. Conversely, the protection buyer retains the client relationship without retaining the credit risk (Azarchs, 2003:12).
2.1 Total Return Swaps
A total return swap is a derivative contract whereby one party, the total return receiver or rate payer, makes periodic fixed or floating rate payments to another, the total return payer, and receives from
34 The credit spread is the difference between the yield on the borrower’s debt, i.e. the reference asset, and the yield on a
risk-free security of the same maturity. Since a risk-free security such as a government bond is free of any default risk, the credit spread provides a measure of the extra yield investors require to compensate for default risk.
the total return payer the total return, that is the interest payments plus or minus price changes, of a reference asset for the period of the contract (Herring, 1998:14).