The Handbook of Financial Instruments

Chapter 31 Credit Derivatives

Moorad Choudhry^*

Senior Fellow Centre for Mathematical Trading and Finance City University Business School

With the exception of holders of default-free instruments such as U.S. Treasuries or British Gilts, a key risk run by investors in bonds is credit risk, the risk that the bond issuer will default on the debt. To meet the need of investors to hedge this risk, the market uses credit derivatives. These are financial instruments originally introduced to protect banks and other institutions against losses arising from credit events. As such, they are instruments designed to lay off or take on credit risk. Since their inception, they have been used by portfolio managers to enhance returns, to trade credit, for speculative purposes, and as hedging instruments.

In this chapter we provide a description of the main types of credit derivatives and how they may be used by fixed-income portfolio managers. We also consider how the risks in credit default swaps may sometimes not be fully understood, and how this highlights the need for more awareness on the legal and documentation aspects of such instruments.

CREDIT RISK

Credit derivatives allow investors to manage the credit risk exposure of their portfolios or asset holdings, essentially by providing insurance against a 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, ...