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Credit derivatives are bilateral contracts that transfer credit risk between two counterparties. It is basically insurance against the non-payment of a credit (a bond for example), where the protection buyer pays a premium to the seller in exchange for receiving a payment in case of non-payment of that credit.
The figure of the “protection buyer” pays an amount to the other counterparty, the “protection seller”, and the buyer receives in exchange the right to receive a payment, which will only occur in the event of a credit event ( default, bankruptcy, restructuring, etc.) of the reference asset or the reference entity of the credit derivative.
The credit derivative ensures the default of a credit to which the buyer is entitled to receive for owning another asset. For example, a company acquires a public debt bond that gives it the right to receive an interest credit from the State. The company can buy a credit derivative in case the State fails to pay interest and thus receive its interests from the “insurer” of the credit derivative.
The credit derivatives market has developed enormously in the last 10 years, it has gone from being a tremendously illiquid and OTC (Over the Counter) market to being a liquid market, thus benefiting all its participants.
Market liquidity benefit
Participants benefit from the liquidity of this market. Imagine that a bank “A” has a long-term business relationship with a company “B”, that is, it provides money and other financial services to the company. Over time, the volume of loans to this company is too much for the bank’s loan portfolio (remember that for a given solvency of company “B”, the bank has limited the number of loans for consuming too much risk).
The bank wants to continue doing business with the company, for two reasons:
- If you continue lending to the company, the rest of the financial services are more likely to continue with the bank, and not go to another.
- It is possible that the loans in the bank’s portfolio have a conflict with the new loans that the bank may grant.
Credit derivatives allow the bank to continue giving loans to company “B”, since these derivatives transfer the credit risk of the loans to another counterparty.
Characteristics of credit derivatives
As we mentioned, credit derivatives have undergone a great development in recent years, in complexity and size.
Derivatives can be found on a single name, where the risk of a single entity or reference is transferred. The best-known derivative on a single reference name is the Credit Default Swap (CDS), which is used to build CDS on several reference names (CDS baskets) or on indices (CDS indices). On the other hand, there are also derivatives on various reference names (multi-name), where the instrument will be activated if any credit event occurs in any of the reference names.
The credit derivatives can also be financed (funded) or not in the opposite case of unfunded (unfunded), in which case the notional is not exchanged between the counterparties until the credit event occurs, in addition, another characteristic of the unfunded is that the protection buyer pays a periodic premium to the protection seller. On the other hand, we have the funded, where the notional of the derivative is exchanged.
Finally, derivatives can be referenced to private entities (non-sovereign entities -corporations-) or to governments (sovereign entities -governments-), it is very important to distinguish between both categories for the following reasons:
- Government derivatives are more complex in that it is necessary to model whether those governments will pay their debtors.
- The government credit derivatives market is much smaller than that of private entities, being unable to extract empirical data to compare credit models.
- The credit analysis that must be carried out for governments is more complex, taking into account the risks of the macroeconomic environment.
Types of credit derivatives
Depending on the type of asset that the credit derivative insures, we find several types of derivatives, such as MBS, ABS and others. Don’t be scared by the nomenclatures because they are exactly the same but with different assets. Credit derivatives are also differentiated according to how the counterparty will be paid or how the premium is paid. If you want to know more, visit the article on types of credit derivatives to know all the types that exist.