Credit Derivatives and Structured Credit: A Guide for Investors

Introduction

The past three decades in the capital markets have been characterized by the explosive growth of derivatives (futures, options, swaps, etc.). These are financial instruments the value of which depends on the fluctuations of an underlying asset, be it a corporate stock, an interest rate, a currency rate, an economic or financial index, or the price of another financial derivative.

Derivatives were designed to provide capital market players with efficient financial risk management tools (financial risk is traditionally measured by the price volatility of financial assets). The main advantage of derivatives is to enable the unbundling and individual management of the risks contained in a single financial asset. Let us take for example an American institutional investor looking to take a long position (i.e. buy) in a corporate bond issued in euros by a French company (say, France Telecom). This investor will bear at least three types of financial risk:

1. An interest rate risk depending on the bond coupon format, either fixed rate (i.e. paying a fixed percentage of par every year) or floating rate (variable coupon paying a spread over a market reference rate such as Euribor).
2. A currency risk as the performance of the investor will be measured in US dollars and the bond generates euro-denominated cash flows over time.
3. A credit risk related to the bond issuer, France Telecom, which, in the event of business problems or liquidity crisis, may not be in a position to pay the ...