Credit Derivatives: Trading, Investing and Risk Management, Second Edition

7

Introduction to Credit Derivatives

7.1 PRODUCTS AND USERS

Our purpose here is to give an outline of the credit derivative products traded, and to give some indication of how the market has developed. We shall define and examine these products in greater detail in Parts II to IV.

7.1.1 ‘Traditional’ Credit Instruments

Fixed income derivative traders regard fixed income bonds as derivatives - they use the same techniques and models to value both cash and derivative instruments. Similarly, we shall regard credit bonds and loans as credit derivatives. We shall present models that cover these instruments as well as the more obvious credit derivatives.

The traditional credit market covers many more instruments than simply bullet debt. Callable or puttable debt follows the same pattern as for the non-credit market. Such bonds require a model of interest rates and credit (spread and default risk). In addition, convertible debt gives an option to exchange the bonds for a certain number of shares. These add a third dimension to the model requiring equity prices also to be modelled.

Commercial banks have been offering a variety of derivatives of varying complexity for nearly as long as they have been granting loans. A ‘guarantee’ or ‘letter of credit’ is economically the same as insurance on a specific debt, and is similar to a single name credit default swap. A ‘facility’ or ‘standby facility’ is an agreement to lend a certain amount of money at a fixed spread (over LIBOR, for ...