11 - Credit derivatives

Abstract

This chapter presents a discussion on credit derivatives. Investment banks are active buyers and sellers of credit derivatives and run a credit derivatives desk. Buyers of credit derivatives free up credit lines by reducing counterparty exposure and sellers enhance returns by assuming more credit risk. Typical sellers of credit protection are insurance companies that presumably use their expertise in evaluating credit to seek additional exposure to credit risk, thereby enhancing returns. All types of credit derivatives can be classified as either single name or multi-name credit derivatives. A single name credit derivative is one in which the credit risk of just one entity is traded, whereas a multi-name credit derivative is one in which the credit risk of a group of entities is traded. The most common single name credit derivatives are credit default swaps, asset swaps, credit spread options, and the total return swap. Multi-name credit derivatives include basket swaps, portfolio credit default swaps, and credit-linked notes.