Credit Risk and Credit Derivative Instruments

Credit risk is the risk of loss arising from the inability of a borrower to make interest and/or principal repayments on a loan. Anyone who has lent funds to a borrower that is not considered as default risk-free is exposed to a certain level of credit risk. While credit risk has been a factor for investor concern ever since the development of capital markets, it has received considerable attention among market participants since the 1990s. This attention has taken the form of ever more sophisticated methods of measuring credit risk and managing credit risk. It is the latter that is the backdrop to the instruments discussed in this book. An understanding of the former is necessary, therefore we will begin with a look at credit risk and credit risk measurement.

Credit derivatives are important tools that are used in the managing and hedging of credit risk, and also for trading and investing in credit, as we shall see. All credit derivatives are instruments, financial contracts in fact, that enable credit risk on a particular named asset or borrowing entity, the reference entity, to be transferred from one party to another. In essence, one party is buying protection on the reference entity from the counterparty, who is selling credit protection. The buyer pays a premium to the seller during the life of the credit derivative contract in return for receiving credit protection. The seller agrees to pay the buyer a pre-specified amount ...

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