Credit derivatives facilitate the trading of credit risk, and therefore the allocation of risk among market participants. They resemble bilateral insurance contracts, with one party buying protection against default losses, and the other party selling that protection.
The growth in the synthetic collateralized debt obligation market, alongside the expansion of the credit derivatives market, has been phenomenal.
A synthetic collateralized debt obligation CDO is a financial instrument that allows debt assets to be securitized into one or more classes of notes.
This is done by way of a transfer of the risk in the relevant debt assets to a special purpose vehicle SPV through the use of credit derivatives. Instead, the economic effect of the transfer of the reference portfolio is replicated using a credit derivative structure. Synthetic CDOs are either documented as standalone transactions using new contracts for each transaction or alternatively set up using programme documentation.
Bouteille and Harwood discuss different types of credit derivatives namely single and multi name basket credit derivatives, sellers of credit derivatives, limitations of credit derivatives and how to make best use of credit derivatives market.
Sellers of credit derivatives fall into two main categories namely those who wish to assume credit risk like insurance companies and those who wish to broker credit risk like investment banks. Companies can make best use of credit derivatives if they are proactively managing and monitoring their credit risk portfolio.
Pelham discusses the use of credit derivatives for corporates.
Corporates find that credit derivatives offer more than just a safety net. Growth of credit derivatives is also impacting the treasury activity of corporates. Credit derivatives also allow corporate to take more proactive positions in the bond issuance than they could in the past.
Apart from credit risk management, credit derivatives also help in fund raising, short term investment and balance sheet management. Credit derivatives are ideal for mid-size and small corporates that cannot access capital markets.
Credit linked notes help in short term investment and selling credit protection can help with balance sheet management. Cocco illustrates the fundamentals of credit derivatives documentation technology and provides an update on recent developments introduced by the International Swaps and Derivatives Associations ISDAthe association of leading participants in the privately negotiated derivatives market.
ISDA is currently working on the new credit derivatives documentation standard: The definitions are a set of standard contractual provisions that can be incorporated by reference into confirmations relating to credit derivatives.
These definitions provide for a number of fallbacks whist apply in case parties do not specify otherwise. Josephson presents information on the use of credit derivatives, a privately negotiated agreement, for electric companies.
He illustrates the benefits of the credit derivatives to electric companies also studies the percentage of the compound annual growth rate in the credit derivatives market.
He says that though credit derivatives are sparingly used by corporations including electric companies, these instruments have the potential to become a valuable tool for companies trying to manage credit risk including electric companies. The increased use of these instruments has been fueled by the decline in the quality of corporate credit.
The advent of credit indices has propelled the market, these products are tailor made for electronic trading. These are the most liquid credit derivatives and have tight margins and they are also not too volatile as they are traded on so many names which make them ideal for electronic trading.
He deals with various definitions of credit derivativescounterparties involved, different types of credit event and also various forms of credit derivatives.
He also provides the credit derivatives market share product wise.
He studies the regulatory environment of credit derivatives and brings forth some relevant issues for banks such as which hedge accounting treatment is apt for which type of credit derivative? Are loan commitments credit derivatives? What disclosures are required for various classes of SPVs?
There are two types of synthetic CDOs namely arbitrage and balance sheet. Arbitrage CDOs are used by asset management companies, insurance companies and other investment firms. Balance sheet CDOs are primarily used by banks to manage regulatory and risk based capital.Review of Literature on Credit Derivatives.
Giesecke, K. () says that a credit derivative is a financial instrument whose cash flows are linked to the financial losses due to default in a pool of reference credit securities such as loans, mortgages, bonds issued by corporations or governments, or even other credit derivatives.
Credit derivatives facilitate the trading of credit risk, and. Credit Default Swaps: Past, Present, and Future Patrick Augustin,1 Marti G asset pricing, CDS, credit risk, derivatives, market structure, sovereign debt with the market practices, public debates, and regulatory initiatives in this market.
We selectively review the extant literature, identify remaining gaps, and suggest directions for. Credit default swaps (CDS) and collateralized debt obligations (CDO) are both types of derivatives.
Derivatives can be used to “hedge” or mitigate the risk of economic loss arising from changes in the value of the underlying item.
Sovereign Credit Default Swap Premia Forthcoming, Journal of Investment Management Whether for right or wrong, credit default swaps (henceforth CDS) have been bedeviled as weapons In section 4, I review the literature on the determinants of sovereign CDS.
Section 5 reviews. Literature Review – Credit Derivatives Pages: 1 2 Doyle and Hudd () set out some basic tips on documentation of synthetic collateralized debt obligations and the potential legal issues that can arise during the structuring process. The Liquidity of Credit Default Index Swap Networks Richard Haynes 1 and Lihong McPhail 2 June Credit index swaps are the most actively traded credit-related instrument in the global derivative market.
Credit indices were first introduced in and provide a means of diversified credit Literature Review.