Advanced Credit Risk Analysis and Management

19

Credit Derivatives

Most financial intermediaries view credit portfolio management as comprising a strategy of portfolio diversification backed by limit caps, with the occasional sale of a credit asset in the secondary market. The advent of credit derivatives has been heralded as a path-breaking innovation that enables institutions to manage credit risks differently with more flexibility. We will discuss the various aspects of credit derivatives, how they contribute to credit risk mitigation and the need for credit risk analysis expertise by both parties involved in a credit derivative.

19.1 MEANING OF A CREDIT DERIVATIVE

Credit derivatives enable banks and other institutions to hedge credit risk or to guard against deterioration in the value of their credit portfolio. A credit derivative is a bilateral contract that transfers the entire (or specific aspects of) credit risk on a specified debt obligation to another party. There are two parties to a credit derivative:

1. Protection buyers are those who seek to protect the credit asset (e.g. loan or bond) they have or intend to acquire.

2. Protection sellers provide the protection or insurance on credit risk for a premium. Credit derivatives can be structured either as unfunded or funded contracts that transfer credit risk between two parties without actually transferring the underlying asset.

Credit derivatives allow holders of credit assets or fixed income securities to trade off some (or all) of the credit risk on the assets ...