CHAPTER 14 Credit Derivatives I: Instruments and Applications

Credit derivatives allow investors to manage the credit-risk exposure of their portfolios or asset holdings, essentially by providing insurance against a deterioration in credit quality of the borrowing entity.1 If there is a technical default by the borrower2 or an actual default on the loan itself, and the bond is marked down in price, the losses suffered by the investor can be recouped in part or in full through the payout made by the credit derivative.

CREDIT RISK

Credit risk is the risk that a borrowing entity will default on a loan, either through inability to maintain the interest servicing or because of bankruptcy or insolvency leading to inability to repay the principal itself. When technical or actual default occurs, bondholders suffer a loss as the value of their asset declines, and the potential greatest loss is that of the entire asset. The extent of credit risk fluctuates as the fortunes of borrowers change in line with their own economic circumstances and the macroeconomic business cycle. The magnitude of risk is described by a firm’s credit rating. Ratings agencies undertake a formal analysis of the borrower, after which a rating is announced. The issues considered in the analysis include:

  • The financial position of the firm itself; for example, its balance-sheet position and anticipated cash flows and revenues.
  • Other firm-specific issues such as the quality of the management and succession planning. ...

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