Credit Derivatives and Structured Credit: A Guide for Investors

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Second-Generation Credit Derivatives

The market in credit derivatives has benefited from the increased sophistication of financial techniques, not least in equity and interest rate derivatives. Thus, using the existing building blocks in the credit market, especially CDSs, the investment banks have been quick to find the theoretical resources and engineering skills needed for designing more complex structured products that met investors’ every need.

The purpose of this chapter is to present these ‘more complex’ products that we call ‘secondgeneration or structured credit derivatives’. We shall divide them into three main categories.

1. Basket credit default swaps or correlation products.¹ With the standardization and growing liquidity of the first-generation credit derivatives market, new opportunities to use them, not least as investment products, have opened up. One of the main changes in the credit derivatives market has been the development of products indexed on credit risk baskets. These enable investors to take a leveraged exposure on an underlying basket of reference entities: these are basket credit default swaps.
2. Hybrid products. The second change in the credit derivatives market is its growing interpenetration with the other derivatives markets. Thus, hybrid products have been developed that enable investors to take highly leveraged positions by playing on several strategies simultaneously. These instruments range from the simplest (capital-guaranteed CLNs) to more complex ...