Credit Derivatives – Overview, Examples, Uses
Credit derivatives are a type of financial contract that allow investors to hedge or speculate on credit risks.
They came into popularity in the early 1990s in the aftermath of a slow-moving global credit crisis that heavily hit commercial real estate (and especially Japan’s economy) and the savings and loan (S&L) industry.
Credit derivatives can be used to protect against credit events, such as a company going bankrupt or a bond defaulting. They can also be used to bet on credit movements, such as whether a company’s credit rating will go up or down.
Some traders and investors will also use them as a way to bet on movements in the credit quality of a particular sovereign country.
Credit derivatives are complex contracts and can be difficult to understand.
However, they have become an important part of the global financial system. The notional value of credit derivatives outstanding is now well over $100 trillion.
History of credit derivatives
Credit insurance dates back to at least the 1860s. These were used to help protect against losses against loans and other liabilities.
The credit derivatives market is a relatively nascent market, with the markets starting to become mainstream in the early 1990s.
At the time, in particular, credit derivatives were used to protect against credit losses on bonds issued by emerging market countries and especially companies within those countries.
The credit derivatives market grew rapidly in the 2000s. The notional value of credit derivatives outstanding exceeded $1 trillion for the first time in 2004 and surpassed $5 trillion by 2007.
The financial crisis of 2008 led to a sharp contraction in the credit derivatives market. The notional value of credit derivatives outstanding fell from a then-peak of $62 trillion in 2007 to $26 trillion by the end of 2009.
The credit derivatives market has since recovered and is now bigger than ever. The notional value of credit derivatives breached the $100 trillion mark for the first time in 2017.
Credit default products are the most popularly traded credit derivative products.
These include unfunded products such as credit default swaps (CDS) and funded products such as collateralized debt obligations (CDO).
The main market participants in the credit derivative markets include:
- banks
- hedge funds
- insurance companies
- pension funds, and
- other corporates
Banks are commonly sellers of these products, taking on the risk and executing various hedging arrangements to get rid of it, while the others are usually (but not always) net buyers of them.
Types of Credit Derivatives
Credit derivatives are primarily divided into two different categories:
- unfunded derivatives
- funded derivatives
Unfunded credit derivatives
An unfunded credit derivative is a credit derivative where one party, the protection buyer, pays a periodic premium to another party, the protection seller, in exchange for credit protection.
The protection buyer is typically an institution such as a bank or insurance company that wants to protect itself against credit losses.
The protection seller is typically a financial institution that wants to earn a fee by selling credit protection. Credit default swaps (CDS) are the most common type of unfunded credit derivative.
Unfunded credit derivatives products include:
- Credit default swap (CDS)
- Total return swap
- Credit default swaption
- First to Default Credit Default Swap
- Portfolio Credit Default Swap
- Secured Loan Credit Default Swap
- Constant maturity credit default swap (CMCDS)
- Credit Default Swap on Asset Backed Securities
- Recovery lock transaction
- Credit Spread Option
- CDS index products
Funded credit derivatives
A funded credit derivative is a credit derivative where one party, the protection buyer, buys credit protection by buying a debt security from the other party, the protection seller.
The debt security is known as the reference asset and provides collateral for the credit derivative contract.
Credit derivatives can be either bilateral or cleared.
A bilateral credit derivative is a contract between two parties that is not cleared through a central counterparty (CCP).
A cleared credit derivative is a contract that is processed through a CCP, which acts as an intermediary between the two parties.
A credit default swap (CDS) is a type of credit derivative that allows investors to protect themselves against credit events, such as a company going bankrupt or a bond defaulting.
A CDS is an unfunded credit derivative.
Funded credit derivatives products include:
- Credit-linked note (CLN)
- Synthetic collateralized debt obligation (CDO)
- Constant Proportion Debt Obligation (CPDO)
- Synthetic constant proportion portfolio insurance (Synthetic CPPI)
Key credit derivative products
By and large, the credit default swap (CDS) and total return swap are the key unfunded credit derivative products.
Collateralized debt obligations (CDO) and credit linked notes (CLN) are the key funded credit derivative products.
Credit default swap
A credit default swap is a type of credit derivative that allows investors to protect themselves against credit events, such as a company going bankrupt or a bond defaulting. A CDS is an unfunded credit derivative.
A credit default swap (CDS) is a contract between two parties in which the protection buyer pays a periodic premium to the protection seller in exchange for credit protection. The protection buyer is typically an institution such as a bank or insurance company that wants to protect itself against credit losses.
The protection seller is typically a financial institution that wants to earn a fee by selling credit protection. Credit default swaps can be either bilateral or cleared. A bilateral credit default swap is a contract between two parties that is not cleared through a central counterparty (CCP).
A cleared credit default swap is a contract that is processed through a CCP, which acts as an intermediary between the two parties.
A credit default swap provides protection against the credit events of a single name or a basket of names.
Total return swap
A total return swap is a type of credit derivative that allows investors to exchange the credit exposure of two different entities. The total return swap can be used to hedge credit risk or to speculate.
The protection buyer is typically an institution such as a hedge fund, bank, or insurance company that wants to protect itself against credit losses.
The protection seller is typically a financial institution that wants to earn a fee by selling credit derivatives.
A total return swap can be either bilateral or cleared. A bilateral total return swap is a contract between two parties that is not cleared through a central counterparty (CCP).
The main difference between a credit default swap and a total return swap is that a credit default swap provides protection against the credit events of a single name or a basket of names, whereas a total return swap provides exposure to the credit events of two different entities.
Collateralized debt obligation
A collateralized debt obligation (CDO) is a type of credit derivative that allows investors to pool credit risk by buying debt securities from multiple issuers.
The CDO can be used to hedge credit risk or to speculate.
The protection buyer is typically an institution (e.g., banks, investors, insurance firms) that wants to protect itself against credit losses.
The protection seller is typically a financial institution that wants to earn a fee by selling credit protection.
A CDO can be either bilateral or cleared.
The key difference between a credit default swap and a collateralized debt obligation is that a credit default swap provides protection against the credit events of a single name or a basket of names, whereas a collateralized debt obligation allows investors to pool credit risk by buying debt securities from multiple issuers.
Credit linked note
A credit linked note (CLN) is a type of funded credit derivative that allows investors to protect themselves against credit events, such as a company going bankrupt or a bond defaulting.
A CLN is structured as a security with an embedded credit default swap allowing specific credit risk transferrence to other credit investors. The issuer is not obligated to repay the debt if a specified credit event occurs.
The protection buyer is typically an institution such as a bank or insurance company that wants to protect itself against credit losses.
The protection seller is typically a financial institution that wants to earn a fee by selling credit protection.
A CLN can be either bilateral or cleared.
Pricing
Credit derivatives are often hard to price.
This is for a few reasons:
1) It’s not always easy to monitor the price of the underlying credit asset.
Some aren’t publicly traded and some literally don’t trade at all most days of the week (even though the market for them is open).
2) It’s not easy to know the creditworthiness of the debtor. This can be especially true if they’re a private entity.
3) Credit rating agencies might not always agree on the creditworthiness of a debtor.
4) Companies don’t default often and so it may be hard for traders, investors, and other market participants to ascertain what fair value should be for a credit obligation let alone pricing it with a model.
Risks of credit derivatives
Credit derivatives are hard to regulate because:
a) they can be difficult for regulators to understand, as it’s typically not their background, and
b) those who are most knowledgable about them tend to have incentives to encourage growth and lack of regulation in these markets.
Experts on credit derivatives in academia – who may have more of a theoretical understanding of these markets rather than knowing them as a market practitioner might (through trading experiences) – may also have incentives to see them continue.
This might include not just receiving consulting fees, but the want for these markets to continue to aid in future research.
Other risks to these markets include:
- credit event
- company going bankrupt
- bond defaulting
- counterparty risk (can each party make due on its obligations?)
- liquidity risk (how easy is it to trade in and out of)
Material credit events may help buyers of credit derivatives, but they can be very dangerous for those selling credit derivatives.
The extent of their losses may exceed the premium they received from selling credit protection.
This is, of course, analogous to losing a lot on standard vanilla options where losses can easily exceed the premium obtained from selling them.
Selling volatility, in general, can be dangerous and potentially ruinous.
Potential for excess speculation
Moreover, credit derivatives can be helpful in hedging credit risks, which is prudent.
But they can also lead to excessive speculation and credit rating inflation that may give traders and investors a sense of complacency.
Those buying credit derivatives know the most they can lose on the transaction is the premium.
So, those selling them could potentially stand to incur massive losses should these positions go against them.
If this were to cause large, systemically important firms to lose a lot of money and run short of money or capital to adequately plug these losses, it can lead to potential insolvency and broader economic problems.
Benefits of credit derivatives
Hedging
Credit derivatives are often used by companies as a way to hedge credit risks.
Hedging credit risks means that the company is protected against losses in the event that one of its debtors defaults on its loan.
There are two main ways that companies use credit derivatives to hedge credit risks:
1) buying protection in the form of a credit default swap and
2) buying debt securities that are collateralized by the loans of multiple debtors.
An extra option to have credit exposure in a portfolio
Companies can also use credit derivatives to speculate on credit risks.
Speculating on credit risks means that the company is betting that one of its debtors will default on its loan. Or that the implicit probability of default will go up.
Credit derivatives can be a prudent way to have some level of exposure to credit in a portfolio, which can help with diversification or other return-enhancing and/or risk-reducing portfolio strategies.
Betting on credit in a risk-limited way
Credit derivatives mean that traders, investors, and other market participants don’t necessarily have to take positions in the underlying credit markets.
This helps them take positions in a risk-limited way.
If they’re wrong, they might only lose a little bit because the maximum extent of their losses is the premium they paid. If they’re right, they can make a lot.
Buying derivatives traditionally yields a type of convexity in a portfolio where the upside can be much higher than the downside.
Credit rating agencies
Credit rating agencies are organizations that rate the creditworthiness of companies and countries.
The credit rating of a company or country is an indicator of how likely it is to default on its loans.
There are three main credit rating agencies: Moody’s, Standard & Poor’s, and Fitch.
Central counterparty
A central counterparty (CCP) is an organization that processes cleared credit derivatives contracts between two parties.
A CCP acts as an intermediary between the two parties and processes the contract according to the rules of the CCP.
CCPs are important because they reduce credit risks in the credit derivatives market.
When two parties enter into a credit derivatives contract, they are essentially betting on whether the debtor will default on its loan.
If one of the parties to the contract goes bankrupt, the other party can’t enforce the contract against them and may not get their money back.
A CCP reduces this risk because it guarantees that either party to the contract will get paid if one of them goes bankrupt.
Credit Risk Models
The Jarrow-Turnbull model and Merton model are two of the most popular credit risk models.
Merton Model
The Merton Model is a model that calculates the default probability of the company based on how well it can service its debt and the general possibility that it will default on its obligations. It was developed by Robert A. Merton in 1974.
The Merton model is a “structured model”, which means that bankruptcy risk is modeled based the firm’s capital structure (how a company is funded between debt, equity, and other forms of financing).
The underlying assumption is that the company’s equity value is a call option on the value of the company, struck at the nominal value of the liabilities.
Because options are partially priced based on the volatility of the underlying asset, the market value of the equity would therefore be dependent on the volatility of the company’s assets.
In general, it does make sense that the equity value of a company could be considered a call option on the company.
Shareholders could choose not to pay the company’s debt obligations if the value of the firm is less than the value of the outstanding debt.
If the company’s value is greater than the debt value, the shareholders would still choose to pay the debt (i.e., essentially exercising their option) and not liquidate the company.
Merton’s model treats bankruptcy as a continuous probability of default. If default does occur, then the stock price of the defaulting company is assumed to go to zero.
Jarrow-Turnbull Model
The Jarrow-Turnbull model was developed by Robert A. Jarrow and Stephen A. Turnbull in 1995.
Unlike the Merton Model, which is a “structural model”, the Jarrow-Turnbull model is a “reduced form” model.
The reduced form approach is a process that weights the company’s probability of default and bankruptcy as a statistical process.
This contrasts with the “structural” modeling process where the probability of default is modeled based on the firm’s underlying capital structure, where the probability of default is based on the random variation in the value of the firm’s assets, which is unobservable.
When financial institutions use default models, they will use both the structural and reduced form types, potentially in addition to their own proprietary ones.
Conclusion
Credit derivatives are contracts between two parties that allow investors to protect themselves against credit events, such as a company going bankrupt or a bond defaulting.
Credit derivatives can be bilateral or cleared.
A bilateral credit derivative is a contract between two parties that is not cleared through a central counterparty (CCP).
A cleared credit derivative is a contract that is processed through a CCP, which acts as an intermediary between the two parties.
The key difference between a credit default swap and a credit derivative is that a credit default swap provides protection against credit events or can be used to speculate on credit quality, while a credit derivative can be any number of instruments that allow investors to hedge or speculate on credit events.
They may fit into clean categorical buckets (e.g., CDS, CDO, CLN) or they may be unique and custom designed for a particular purpose or exposure.
They are often designed and issued by investment banks, though any type of investor can engineer a credit derivative and sell it so long as they find a counterparty.
Credit derivatives can be helpful in hedging credit risks, but they can also be risky and lead to excessive speculation and credit rating inflation.