Credit derivatives are a form of credit insurance. e-Bank has funded a loan to corporate client ABC. It is willing to fund the loan and keep it on its balance sheet, but it does not want to face the credit risk, that is the losses resulting from a default of the corporate client. So e-Bank will search for a counterparty – this could be another bank, an insurance company, or an investment fund – willing to assume the credit risk. Credit derivatives facilitate the transfer of credit risk.
Here is the (simplified) balance sheet of e-Bank.
|e-Bank’s balance sheet|
|Loan to corporate ABC||Deposits Equity|
Three types of credit derivative instruments will be presented: credit default swaps (CDS), total rate of return swaps (TRORS), and ...