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
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
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