Credit Derivatives II: Funded Instruments

We have noted that credit derivative instruments exist in funded and unfunded variants. The previous chapter looked at unfunded credit derivatives. In this chapter we consider funded credit derivatives, by which we mean principally the credit-linked note (CLN) and also some versions of total return swaps (TRS).


CLNs are a form of credit derivative. They are also, in all their forms, bond instruments for which an investor pays cash upfront, in order to receive a periodic coupon and, on maturity or termination, all or part of its initial purchase price back. That makes CLNs virtually identical to cash bonds. The key difference is that the return on the CLN is explicitly linked to the credit performance of the reference security or reference entity. Like all credit derivatives, CLNs are associated with a reference entity, credit events and cash or physical settlement.

CLNs are funded credit derivatives. The buyer of the note is the investor, who is the credit protection seller and is making an upfront payment to the protection buyer when it buys the note. Thus, the credit protection buyer is the issuer of the note. If no credit event occurs during the life of the note, the par redemption value of the note is paid to the investor on maturity. If a credit event does occur, then on maturity, a value less than par will be paid to the investor. This value will be reduced by the nominal value of the reference asset ...

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