Credit options have strong appeal to institutional investors as a
source of yield enhancement, generating exposure to a credit where the
bond is unavailable – the investor is short a credit collecting income in
return for the risk of losing an asset in the future (in the case of a call).
Other users of credit options are banks and dealers who seek to hedge
their marked to market exposure to variations in credit spreads. As
these institutions run leveraged balance sheets the off balance sheet
nature of the position created by a credit option is attractive.
3.9 Credit linked note
Credit linked notes (or CLNs) allow exposure to a credit in funded form.
It seems to the investor like a conventional credit bond. But behind
the façade is a subtle piece of financial engineering. They are com-
monly packaged within the debt issued by an SPV (Figure 3.17). The
vehicle enters into a default swap arrangement with a counterparty
buying protection. This resulting premium is passed on to the investor
who consequently has an enhanced yield relative to the risk free rate.
The SPV uses the funding to secure collateral. In the event of a credit
event the collateral is used to make the compensating payment to the
protection buyer. The investor bears the credit risk on both the refer-
ence entity and the collateral.
3.10 First to default
These types of credit derivatives have increased in popularity mainly
due to the fact that the investor can leverage their credit exposure,
160 Credit risk: from transaction to portfolio management
High grade
Par or recovery
L x bps
Credit risk transfer
Figure 3.17 Note issued by SPV.
without increasing their downside beyond the first name that defaults.
Further the premium received will usually be much higher than sell-
ing protection on just one name. A very recent development has been
the supply of index swaps, which pay the return received on a standard
index in return for a floating periodic payment. These are obviously
popular enabling an unfunded exposure to a wide variety of, potentially,
diverse credits.
A first to default note will consist of exposure to a number of credits
with the size being the notional at stake. After the first credit event the
note terminates and the investor must pay the protection seller either
a compensating one-of-payment (cash settlement). Or receive the ‘dam-
aged basket’ and make good the difference between this and par.
In Figure 3.18 the note is written on the three corporates whose yields
are depicted in the figure. We can see that Corp C defaults which would
trigger settlement.
The note will either be cash settled or physically settled in which case
the owner of protection will deliver the damaged asset in return for
par. This is often the case for first to default notes issued by an SPV.
The amount for cash settlement is the difference between par and the
final price of the reference obligation.
The yield that the investor receives on a first to default spread note
will be somewhere between the spread of the worst individual credit and
the sum of the spreads on all. This will be close to the sum of spreads
if the correlation is low and vice versa for high correlation. The reason
for this is that in the case of no correlation the portfolio will have the
properties of a sum of individuals while if they are all correlated they
effectively behave as the worst asset. Figure 3.19 shows the first to
default spread curve and how it depends on correlation. The first to
default spread is equal to the worst in the case where the correlation
is equal to 100 per cent.
Credit derivatives 161
Yield (%)
Time (years)
Corp A
Corp B
Corp C
Figure 3.18 The yields on three companies (% vs. Time).

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