CHAPTER 19

Credit Products

Perhaps the fastest growing area within the derivatives industry is credit derivatives. Simply defined, a credit derivative is an agreement that transfers the credit risk of an asset from one party (the protection buyer) to another (the protection seller). The oldest form of a credit derivative is a guarantee. A guarantee is a contract in which the seller accepts responsibility of the buyer's payment obligation (s) in the event of default. While guarantees have been arranged for thousands of years, two new and different classes of credit derivative contracts began to appear in the early 1990s—credit default products and credit spread products. Credit default products are those whose payoffs are triggered by a “credit event.” A credit event need not be default and can be defined in any way that the two counterparties agree. Some common credit risk realizations are bankruptcy, failure to pay a coupon or to repay the full amount of the bond's principal, an invocation of a cross-default clause such as a more junior bond issue within the firm defaulting, a corporate restructuring that leaves bondholders worse off, and credit deterioration in the form of a downgrade in bond rating.1 In contrast, credit spread products are those whose payoffs are linked to a credit spread, that is, the difference between the yield to maturity on a corporate bond and the yield to maturity of a risk-free bond (e.g., U.S. Treasury bond) with same coupon rate and maturity date. ...

Get Derivatives: Markets, Valuation, and Risk Management now with the O’Reilly learning platform.

O’Reilly members experience books, live events, courses curated by job role, and more from O’Reilly and nearly 200 top publishers.