64 - Introduction to credit derivatives

Abstract

This chapter reviews the market in credit derivatives that are a relatively new instrument but have grown in importance fairly rapidly. The emergence of a market in credit derivatives is one of the most important recent developments in financial risk management. Credit derivatives offer bankers a new way to establish themselves as intermediaries in the credit market. Unlike market risk where traders can move in or out of liquid markets in relatively homogeneous products, credit derivatives are long term illiquid investments. Each borrower is different and presents unique credit risk issues that cannot easily be compared to other parties. A bank can use credit derivatives as part of its portfolio credit risk management. Companies on the other hand can use them to hedge against default by any of their suppliers or creditors or joint venture partners. The loan return is generally based on Libor, which cancels out the Libor paid by the investor. The loan is marked to market at predetermined dates and the buyer receives the asset depreciation or the seller receives the asset appreciation, depending on what the price of the asset is at the time of the maturity of the swap.