Credit derivatives are used to manage and exploit risks and opportunities in credit markets.
Risk is transferred amoung the various participants using OTC transactions.
These allow investors to manage credit risk in the same way they can manage foreign exchange and interest rate risk.
The most popular credit derivative is the single name credit default swap.
Credit derivatives can be funded or unfunded contracts that transfer risk between two parties without actually transferring the underlying asset.
A credit derivative allows the holder to isolate and separate credit risk from the market risk thus allowing this credit risk to be either hedged, traded or transferred.
A Repurchase Agreement is not considered to be a credit derivative.
Different types of Credit Derivatives
Credit derivatives provide a risk management toolkit
The ability to buy and sell credit protection focuses attention on any return differentials existing in similar credit products (asset swapped fixed rate bonds, FRNs, Loans)
The most common credit derivatives are:
Credit Default Swap - single name, basket or or index
This allows an agent to take credit exposure (ie sell or buy credit protection)
Credit Linked Note (CLN) - where the underlying credit risk can be a single name.
Total Return Swap
Other more complicated types of credit derivatives involve structured credit products:
Collaterised Debt Obligations (CDO) - these include Collaterised Loan Obligations (CLO) and Collaterised Bond Obligations (CBO)
Hybrid balance sheet CLOs
Synthetic portfolio trades
Why are they so popular ?
The size of the international debt markets
a market-friendly regulatory environment
liquid asset swap market
they are used to diversify risk
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