CHAPTER 5

Credit Derivatives III: Applications

As derivative instruments are over-the-counter (OTC) contracts, credit derivatives are very flexible products with a wide range of applications. It was their introduction that enabled synthetic structured products to be developed, which are now a major part of the debt capital markets. In Part II of this book we look in detail at synthetic securitisation, in this chapter we present an overview of some basic applications.

MANAGING CREDIT RISK

Credit derivatives were introduced initially as tools to hedge credit risk exposure, by providing insurance against losses suffered due to ‘credit events’. At market inception in 1994, commercial banks were using them to protect against losses on their corporate loan books. The principle behind credit derivatives is straightforward and this makes them useful equally for both protection buyers and sellers. For instance, while commercial banks were offloading their loan book risk, investors who may have previously been unable to gain exposure to this sector (because of the lack of a ‘market’ in bank loans) could now take it on synthetically. The flexibility of credit derivatives provides users with a number of advantages precisely because they are OTC products and can be designed to meet specific user requirements.

We focus on credit derivatives as instruments that may be used to manage risk exposure inherent in a corporate or non-AAA sovereign bond portfolio. They may also be used to manage the ...

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