Credit Derivative, Financial Instrument

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The credit derivative is a financial instrument executing the transfer of part or all of the credit risk to third parties. In the global banking practice, the use of credit derivatives has grown rapidly. If in 1993, after being pioneered by J.P. Morgan’s Peter Hancock, the credit derivatives market estimated approximately $ 40 billion, then in 2007, about $ 35.1 trillion.

One might note that credit derivatives include the following types:

  • Credit swaps;
  • Credit-linked notes;
  • Credit spread options;
  • Hybrid instruments, which, in fact, are a set of the above derivatives and debt instruments. The latter include commitments to payments pools such as debt obligations, CDOs, index swaps, and an option on the credit spread.

In order to distinguish the credit derivative from other derivatives of risk management such as futures, forwards, and options, it seems essential to pinpoint paramount aspects of credit derivatives. First, they allow diversifying the risks of assets, regions, industry, and market. Credit derivatives are also hedging the risks for the entire period of the underlying asset (in contrast to, for instance, the forwards). What is more, credit derivatives are a payment instrument, in other words, upon the occurrence of a credit event or a risk protection, the seller provides immediate payment to protect the buyer’s interest in the amount determined at the closing. Speaking of the bank’s off-balance sheet financial instruments, credit derivatives allow transferring the risk to the other side without transfer of ownership of assets. Finally, the documentation required for the transaction of credit derivatives is standardized according to ISDA (International Swaps Dealers Association) and consists of a set of specific documents.

It is the project company that is a buyer of credit derivatives. The company is interested in it as the borrower because, in the case of difficulties and delays in payment, the bank is more likely to go for negotiations on restructuring the debt than when the company declares bankruptcy. The project organization, acting as the borrower, remains uninvolved in the contract while the bank along with the third party that buys the risk are not required to notify it of the conclusion of the transaction. Therefore, the third party acts in the role of the seller.

Speaking more precisely, at the heart of the credit derivatives there is the credit event or the implementation of credit risk: default (failure to comply with the obligations of the project company) or a decline in the market value of the asset base lowering the credit rating of the project company. According to the provision of the agreement, the third party provides payment in the case of risk occurrence, but not necessarily the full repayment of the borrower’s obligations. For instance, the organization that sold the credit derivative pays the difference in the value of the asset at a predetermined scheme. Such a condition is positive for the borrower as well because if the asset decline is temporary, the bank financing the project receives sufficient resources to maintain liquidity and performance standards for redundancy without resorting to the sale of debt to the third party.

Pricing of credit derivatives in the financial integration process is ambiguous. On the one hand, they allow redistributing risk and contribute to the integration of the different segments of financial markets reducing the cost of financial intermediation. On the other hand, credit derivatives might cause significant threats leading to the bankruptcy.

In my point of view, the credit derivative possesses both advantages and disadvantages. The credit risk is the advantage. Besides the probability of default of the underlying asset, there might be the default of the seller protection. In this case, the buyer of protection should double losses. In practice, the probability of a simultaneous default on both transactions is extremely low, but it cannot be ignored. For example, the probability of a simultaneous default increases significantly in the case the underlying asset and the seller of protection are in the same area or are related to the same industry. In addition, the cost of protection affects the market risk as the decline in quoted market prices of the underlying asset leads to an increase in credit spread. Another factor that negatively affects the risk of the use of credit derivatives is the need for disclosure of the project company and its founders (participants) information that arises in the case of a credit event for credit derivatives. By signing a bilateral agreement, the bank is obliged to transfer assets and, hence, the information to the third party (the seller). Consequently, there might be a conflict of interests that could adversely affect the bank.

Seeing the above characteristics, it can be assumed that the use of credit derivatives will be extended. Meanwhile, over the past few years, they have undergone a major upgrade. Thus, credit derivatives may have a significant impact not only as a tool to minimize the risks of project financing but also to increase the effectiveness of bank lending in general.

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BusinessEssay. "Credit Derivative, Financial Instrument." April 15, 2022.