Credit Derivatives I: Unfunded Instruments
Credit derivatives are financial instruments that enable credit risk on a specified entity or asset to be transferred from one party to another. Hence they are used to take on or lay off credit risk, with one party being the buyer of credit protection and the other party being the seller of credit protection. They have become a key tool in the management of credit risk for banks as well as other capital market participants. Credit derivatives allow investors to manage the credit risk exposure of their portfolios or asset holdings, essentially by providing insurance against 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. The introduction of credit derivatives has resulted in the isolation of credit as a distinct asset class. This has improved the efficiency of the capital market because market participants can separate the functions of credit origination and credit risk-bearing. Banks have been able to spread their credit risk exposure across the financial system. The use of credit derivatives also improves market transparency by making it possible to better price specific types of credit risk.3
In this chapter we consider the various unfunded credit derivative instruments. ...