2 - Credit Derivative Instruments: Part I

Abstract

This chapter provides an overview of various unfunded credit derivative instruments that may be used to manage risk exposure inherent in a corporate or non-AAA sovereign bond portfolio and to manage the credit risk of commercial bank loan books. The unfunded credit derivative instruments discussed in the chapter are credit-default swap, total-return swaps, and asset swaps. Credit derivatives isolate credit as a distinct asset class; this isolation of credit has improved the efficiency of the capital markets because market participants can now separate the functions of credit origination and credit-risk bearing. Credit derivative instruments enable participants in the financial market to trade in credit as an asset as they isolate and transfer the credit risk. Various applications of the credit derivative instruments and their pricing and valuation are discussed in the chapter. The chapter also discusses credit options, credit-spread options, and credit derivative settlement.