Credit Risk: From Transaction to Portfolio Management

The appeal of this arrangement will depend on the cost of the bal-

ance sheet which is dependent on how the institution is funded. The

more costly the item on the balance sheet the greater the appeal for an

off balance sheet arrangement. For example it makes little sense for a

bank with a speculative grade rating to loan money to an institution

with a higher rating simply because the margin is disadvantageous.

Even lending money to a poorer credit may not be attractive given the

regulatory capital that needs to be set aside as a cushion.

However by taking exposure to loans using a credit derivative the

bank can avoid both the financing and administrative costs of direct

ownership. The degree of leverage achieved will depend on the amount

of upfront collateral required by the counterparty.

Convention in the market

The typical arrangements in the marketplace can cause some confusion.

The buyer of protection is a seller of credit exposure and the seller of

protection is a buyer of credit risk.

Thus if we consider a corporate bond where the owner requires pro-

tection, then he would be a seller of credit exposure since he would be

immune to any deterioration in the issuer, by virtue of being long the

underlying.

Definition of a credit derivative

A bilateral financial contract in which the buyer pays a premium in return

for a contingent payment in the advent of a credit event.

3.3 Definition of a credit event

Credit derivatives are negotiated transactions and because of this the

market development has been hindered by the absence of standard

documentation containing strictly defined legal terminology. This

problem has been addressed by the International Swaps and Derivative

Association (ISDA) which issued a standardized Long Form Confirmation

in 1998 and more recently (July 1999) new definitions encompassed

within the Short Form Confirmation. We list below the ISDA specified

credit events.

The user of a credit derivative must be aware that the instrument does

not always provide protection against either market related ‘events’ that

lead to a spread widening (and consequent losses for bondholders) or

to rating downgrades.

142 Credit risk: from transaction to portfolio management