Introduction to Securitization

APPENDIX A

Basics of Credit Derivatives

Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty to the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitization. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks and rewards commensurate with the risks are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset.

The counterparty to a credit derivative product that acquires exposure to the risk synthetically acquires exposure to the entity whose risk is being traded by the credit derivative product. Thus, the credit derivative trade allows investors to trade in the generic credit risk of the entity without having to trade in a credit asset such as a loan or a bond. Given the fact that the synthetic market does not have several of the limitations or constraints of the market for cash bonds or loans, credit derivatives have become an alternative parallel trading instrument that is linked to the value of a firm—similar to equities and bonds.

When coupled with the device of securitization, credit derivatives have been transformed into investment products. Thus, investors may invest in ...