Counterparty Credit Risk: The new challenge for global financial markets

Chapter 6

Overview of Credit Risk and Credit Derivatives

“Creditors have better memories than debtors.”

Benjamin Franklin (1706–1790)

So far, this book has been largely concerned with credit exposure. Now we aim to describe the default component in more detail. We discuss the nature of default probability, recovery rates and associated credit spreads. The focus will be largely on corporate entities, which are most relevant from the point of view of counterparty risk. We will also review the range of credit derivatives products, which will be discussed in some later chapters. Hence, this chapter is a review of all the key credit risk and credit derivatives aspects and may be skipped by the reader experienced in these areas. However, many subtle questions can only be answered from a detailed knowledge of credit risk and credit derivatives products. For example:

Suppose an institution has an uncollateralised credit exposure of $10m to a defaulted counterparty but they also have $10m of credit default swap protection against the counterparty in question. Is this a perfect hedge?

The short answer to the above question is no but the long answer is much more complex, as we shall explore in both this chapter as well as Chapter 9.

6.1 DEFAULTS, RECOVERY RATES, CREDIT SPREADS AND CREDIT DERIVATIVES

Default probability and the associated recovery rate define the expected loss on an asset. Market credit spreads reflect the market price for such losses and hence a commonly used relationship ...