4 - Credit Derivatives: Basic Applications

Abstract

This chapter discusses the basic applications of credit derivatives. Credit derivatives were initially introduced as tools to hedge credit risk exposure by providing insurance against losses suffered because of “credit events.” Credit derivatives are instruments that may be used to manage risk exposure inherent in a corporate or non-AAA sovereign bond portfolio. It may also be used to manage the credit risk of commercial loan books. There are a number of reasons portfolio managers wish to enter total return swap (TRS) arrangements. One of these reasons is to reduce or remove credit risk. Using TRSs as a credit derivative instrument, a party can remove exposure to an asset without selling it. Credit derivatives allow market participants to separate and disaggregate credit risk and hence to trade this risk in a secondary market. Initially portfolio managers used credit derivatives to reduce credit exposure; subsequently they have been used in the management of portfolios to enhance portfolio yields and in the structuring of synthetic collateralized debt obligations. Portfolio managers' main uses of credit derivatives include enhancing portfolio returns, reducing credit exposure, credit switches, and exposure to market sectors.