Typology of Credit Derivatives and their Main Applications
Credit derivatives may be classified into three main families, depending on their mechanisms and purposes:
- Credit default derivatives. These are without doubt the products considered the most innovative, since they enable trading and hedging strategies that did not exist in the financial markets before their creation. They protect their users against the occurrence of one (or several) credit event(s), generally defined in the contract as the failure to pay of the reference entity.
- Credit spread derivatives. These instruments enable investors to take a position on the future level of the credit spread between two debt securities, independently of the absolute interest rate levels. The value of these products depends on the evolution of the credit spread on the reference securities, but, contrary to the case of credit default derivatives, it is not explicitly linked to the occurrence of certain predetermined credit events.
- Products enabling synthetic replication of the performance of an underlying asset. This type of derivative, which was developed previously on other underlying assets (especially equity), enables investors to replicate the economic performance of an exposure to a credit risk synthetically without being obliged to buy the reference instrument. In exchange, the party synthetically selling his exposure hedges against the credit risk of the underlying asset.
The first category of products has experienced ...